On October 9th, 2017, Richard Thaler, an economist at the University of Chicago, was awarded the Nobel Prize in Economics. Thaler is one of the founders of behavioural economics, having begun his study of the field even before Amos Tversky and Daniel Kahneman brought it into the mainstream. The three would later work extensively together on various foundational theories. Interestingly, one of Thaler’s most significant contributions is an extension of Tversky and Kahneman’s “mental accounting” theory, which builds on the theory of “framing”.
One reason Thaler’s ideas have been so enduring is how he presented them. Mainstream economics has generally relied on the concept of homo economicus – a fictionalized ideal of human beings that always chooses the economically optimal outcome when presented with an array of choices. It is patently obvious that humans do not always act optimally, nor do we obey the numerous economic rules that help to define what optimality actually is. Thaler not only showed that human beings sometimes act irrationally, but also that we act irrationally in predictable ways – and that our predictable irrationality could be leveraged to improve people’s lives.
An example of this predictable irrationality can be found in how people tend to spend unexpected winnings. A cash windfall from winning a hockey pool tends not to be lumped into a mental account that includes savings and everyday cash. People consistently spend winnings, deposited into a “frivolous” mental account, at a much higher rate than normal income, even if there is no difference between a dollar of earnings and a dollar of winnings.
This type of mental accounting also shows up in investing and retirement planning. Clearly a Registered Education Savings Plan (RESP) can readily be earmarked for a child’s schooling, and a Registered Retirement Savings Plan (RRSP) is usually best utilized to plan for retirement. However, it can be easy to fall victim to the mental accounting heuristic when managing several accounts at once. For example, it can be tempting to invest the RRSP aggressively while investing the non-registered account cautiously. It’s very important to remember to view one’s retirement portfolio on an overall basis, while still utilizing tax efficiencies. When managing accounts independently, the overall portfolio can become needlessly complex and deviate from its optimal asset allocation.
At Baskin Wealth Management we are able to manage and analyze your assets and holdings as one portfolio and efficiently accommodate your financial projects and plans. This allows for diversification of investments over a larger portfolio and can help the safety of your investment returns. While you plan for a new car, home renovations, education, everyday expenses, and eventual retirement, we can help you accommodate those plans while keeping your overall portfolio and long-term goals in mind.
October 20, 2017