Quick note to self about the portfolio: mental accounting bias

In a word: fungibility.  Many folks are fans of compartmentalising their portfolios: this amount for housing; this amount for retirement; this amount for kids schooling.  There’s a behavioural investment bias associated with this, called mental accounting.  If memory serves me correctly, the CFA curriculum has a somewhat hand-wavy approach to this bias:

  1. Mental accounting is suboptimal.  The portfolio is all fungible; money is money.  Creating silos can inhibit portfolio return, because it’s possible that more assets are kept in safer or less diversified holdings than if the portfolio was considered as a whole.  So CFA-designated financial advisors: don’t silo your clients’ portfolios.
  2. But…. most people have real difficulty thinking of his/her portfolio as a whole.  It can be scary to think about (say) the kids’ college money being put into risky investments better left for long-duration retirement funds.  In order to sate clients’ needs to ‘see’ certain silos within their portfolios, the financial advisor might relent to this approach.

I think a big area of discussion related to this concept is ‘the emergency fund’ of cash.  Suppose the following, silly example:

  • Single person, aged 35, with annual living expenses of $25,000 p.a.
  • Has a job earning $50,000 p.a., so is saving a fair chunk.
  • Due to lottery winnings/inheritance/previous stock options/etc., the person has a $1,000,000 portfolio.
  • Conventional emergency fund thinking: stash away 3-6 months of living expenses (e.g. $7-12,000) in cash at all times.
  • Total portfolio thinking: keep only necessary liquidity in cash (maybe $2,000, say).  Remainder is put in a portfolio of various assets, with a total return objective.  If bad times happen job-wise, liquidate some of the portfolio.

Which do you feel is better for this person?  What about your own situation?  Hmm…


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