By Melissa Walsh, CFA, CFP®
As serious observers of the economy, we are often reminded that money is fungible and should be compounded by investing appropriately. However, the presence of well-documented biases, such as considering sunk costs and participating in so-called “mental accounting,” demonstrates that many people view money in different ways depending how and why it was earned, spent, or saved. I recently listened to an interview with Richard Thaler, a Nobel Prize-winning behavioral economist, who explained that even he occasionally finds himself engaging in these biases. If even a renowned behavioral economist admits to economic errors, it is easy to conclude that we do, too. A behavioral finance inspired method called the “bucket approach” takes advantage of this realization. For specific situations, this approach is one of several options for account and investment management.
The bucket approach is essentially what it sounds like: creating separate accounts or sub-accounts for different goals or uses of money. For example, opening one account to save for retirement, and one account to save for a near-term purchase, like a house or a boat. The benefit to this approach is that the investor can easily see and keep track of the progress of each goal separately. Being able to easily track one’s progress toward individual goals can serve the important purpose of motivating investors to make the economically logical, but functionally difficult decision to forgo current spending in favor of long-term saving. Additionally, for those accounts that are invested in the markets, a different target asset allocation can be selected to match the time horizon of each goal separately. This may aid investors in sticking with their investment portfolios when it would otherwise be difficult. For example, an investor may be better able to stick with a conservative portfolio when the markets are up because she recognizes the short-term nature of the goal. Likewise, knowing that the money in an aggressively-invested account that won’t be needed for 10+ years may help an investor maintain a more aggressive portfolio when markets are down.
Ultimately, the bucket approach is one way to embrace behavioral finance and help investors optimize their decisions by creating an intersection between real life and economic theory. As wealth advisors, it is this intersection that we seek to recognize and utilize in order to help clients achieve their goals.
For those who are interested, the Freakonmics podcasts in general are excellent, and I found the recent interview with Richard Thaler to be an entertaining and educational reminder of some of the basics of behavioral finance: http://freakonomics.com/podcast/richard-thaler/
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