How Much of Your Income is Mental? Overcoming Human Fallacies in Investing

Publication Type: Investment Cases
How Much of Your Income is Mental? Overcoming Human Fallacies in Investing

Mental accounting is a truly defining feature of the human condition. We naturally sub-divide and categorize all sorts of events and resources, and not just with money either; it is a coping mechanism for our brains. Mental accounting reduces the complexities of the world into bite size pieces ready for human consumption, turning the unfathomable into the intelligible. So useful is this form of budgeting that it is one of the first financial concepts we teach to children: lunch money.

This phenomenon is so ingrained in how we operate that it creeps almost unseen into our financial habits, which makes it natural to question how it may affect income investing. Understanding the hazards of mental accounting, and the risks it poses to income strategies, can reveal solutions that may help investors successfully meet their long-term goals.

After all, there is only one type of money, portfolio money; any account we create, be it a rainy day fund, rent money or lunch money, is only a fiction — just portfolio money by a different name.

The Original Sin of Investing

Despite the inherent convenience of mental accounting, there is one glaring problem; it is all made up. Consider the case of lunch money, for example. Just because we allocate money for lunch does not mean it is suddenly a different type of money deserving of different treatment. After all, there is only one type of money, portfolio money; any account we create, be it a rainy day fund, rent money or lunch money, is only a fiction — just portfolio money by a different name.

Related: How Many Losers Lurk in the S&P 500?

This cognitive bias distorts not only how we value our long-term goals, but more importantly, how we assess the risks we are willing to take to reach these goals. The stories we tell ourselves about how money works give rise to perverse effects, such as creating scenarios where 1 plus 1 equals not 2, but 7.

For instance, losing five dollars of lunch money would be a calamity for an investor, yet it would be a non-event if those same five dollars were lost in a growth equity fund, even though the outcome is identical from a portfolio perspective. All money is one and the same

Mental Income

Despite its status as a mainstay portfolio strategy, income investing is especially prone to the pitfalls of mental accounting. This susceptibility stems from poor understanding of what the ultimate goals are in generating income, leaving ample opportunity for investors to draw upon mental accounting. 

… since income strategies are often paired directly against ongoing expenses, the siren song of mental accounting can be all too tempting.

Challenges arise when investors start creating separate bucket accounts of assets, namely REITs, MLPs and high yield funds, to be paired against ongoing expenses (the concept of lunch money is a stubborn one). The core problem is that this approach fails to take a holistic view of both investor needs and available resources. For instance, why does money generated from “income” assets automatically get allocated to meeting immediate expenses? Moreover, why should money allotted to each of these assets be viewed as a distinct portfolio “sleeve,” each judged by its own standards?  The gymnastics of mental accounting are exhausting, fictions created to meet the needs of yet further illusions. The investor’s attentions are drawn to everything but the portfolio itself.

In escaping the trap of this imaginary accounting, we can see that the idea of separate income accounts is clearly misguided. Concerningly, it precludes investors from taking a top-down view of income generation, encouraging an asset by asset approach instead of assuming a portfolio-centric perspective. By foregoing the potential of intra-asset correlation gains, the opportunity cost to mental accounting in income is real.

Incoming Solutions

How exactly can taking a comprehensive view on income generation improve investment outcomes? It is a classic “the whole is greater than the sum of its parts” scenario, where balancing different assets against each other can smooth out the extremes of each asset on its own. The key ingredients to a high income portfolio, such as Master Limited Partnerships (MLPs), Business Development Companies (BDCs), Closed End Funds and REITs, all have unique risk factors that behave differently over time. Synthesizing these assets together can not only moderate performance, but also create a more diverse income base as well.

Read More: Looking for Income in All the Wrong Places? How to search for 7% Income in Today’s Market

The figure below depicts the risk and return characteristics of these four high yield asset classes (MLPs, CEFs, REITs and BDCs) over four time periods alongside the TFMSHIPS Index, represented by the diamond icons. This index measures the performance of 300 securities drawn from these four asset classes in a diversified manner, and it may be a reasonable benchmark for a top-down approach to income. 

Notes: Shapes indicate asset classes, colors performance periods. Year to date return is total return through 3/31/19, all other performance periods are annualized total returns ending 3/31/19.  All risk measures signify annualized volatility.  REIT performance is based on the US Bloomberg REITs Index, MLP performance is based on the Alerian MLP Index, Closed End Fund (CEF) performance is based on the S-Network Composite Closed End Fund Index, and BDC performance is based on the S&P BDC Index. The TFMSHIPS Index is a diversified index of 300 high income securities drawing from the REIT, MLP BDC and CEF universes.

An immediate observation is that these asset groups perform quite differently over varying time periods, not only in absolute terms but also when compared relative to each other. In other words, what may be the most attractive asset in one time period may have strikingly different performance over another period.

Consider closed-end funds, which offer the best risk/return option over a two-year history, but the worst over a 1 year history (notice how all the two-year assets fall below the purple line, while all the 1 year lie above the green line). Even the distribution of returns looks very different between the YTD and 3 Year performance on the left and the one- and two-year performance on the right. In this context, the TFMSHIPS Index transforms the individually volatile asset returns into a consistent and balanced composite.

Risk/Reward Ranking of Income Asset Classes Over 4 Periods

Notes: This diagram ranks the assets in each time period by their annualized return divided by their annualized volatility (YTD figures are based on total return, not annualized returns). This is a common measure of how much return an asset produces per unit of risk assumed.

To illustrate the gains of a holistic strategy, the chart above ranks the strategies ordinally in terms of risk/reward attractiveness in each period, along with a combined scoring in the right column. The two key points are the volatility of the rankings, and that the TFMSHIPS Index coming only two points behind the closed end funds.

Equally significant is that this integrated index can offer an estimated dividend yield 230 basis points higher than that of the REIT Index at the cost of only 1 point in ordinal ranking. While these results are not truly scientific, they are an illustration of the advantages to taking a portfolio-level approach to income versus simply relying on mental accounting.

Income on the Balance

Income investing occupies a prominent role in meeting long-term objectives, which is why it is imperative to understand how mental accounting can lead even the best astray. Especially since income strategies are often paired directly against ongoing expenses, the siren song of mental accounting can be all too tempting.

This bias can completely flip investment priorities, where investors pursue goals for the sake of their imaginary accounts in lieu of their actual objectives. While good investors may focus on their winners, great investors concentrate on understanding, and ultimately moderating, their own human fallibility. Taking a holistic view of income investing is an important part of this process.

Ryan is Director of Research at GraniteShares, and has focused his career on spanning the divide between traditional active management and indexed strategies. He has worked as an analyst at a number of hedge funds, including Tudor Investment Corporation, before developing first to market, scalable strategies utilizing the ETF wrapper. He graduated from Boston College in the Honors Program with a Bachelor of Arts degree in Economics and Philosophy. He earned his CFA charter in 2019.

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