Our guest blogger is Meir Statman, finance professor at Santa Clara University. He's a leading light in the field of behavioral finance and those insights illuminate his new book, What Investors Really Want.
A key concept in behavioral finance is the notion of mental accounting, the realization that labels matter. Money may be money, but to help us manage our money we label one account, say, our emergency money and another our fun fund.
Mental accounting helps us follow through on our spending, saving and investing decisions. Statman uses the concept to illustrate a common problem confronting retirees living off their investments:
We use mental accounts when we deal with dividends from stocks and interest from bonds. We put them in "income" mental accounts. They are distinguished from our "capital" mental accounts which contain the stocks and bonds themselves. There are clear boundaries in our mind between accounts containing income and accounts containing capital.
There are clear boundaries in our mind between accounts that reflect income from our investments and accounts with the actual investments. These mental accounts also come with rules that prohibit violating the boundaries of these mental accounts. That helps us when we are tempted by weak self-control to dip into capital--to eat our financial seed corn. We feel free to spend income (money from the dividend or interest account), but we prohibit ourselves from dipping into capital by selling stocks or bonds and spending the proceeds.
Yet retirees are in a difficult spot when interest rates and dividend rates drop close to zero--like now. They can choose to live on a diminished income or dip into capital. Tey don't like either choice.
Instead, retirees evade the don't-dip-into-capital rule by making "obscure" dips into capital. For instance, a mutual fund that invests in Japan excels at obscuring dips into capital. The fund sends its shareholders monthly checks it labels dividends. But the checks include both dividends received by the mutual fund from the stocks it holds and capital gains realized from increases in the prices of these stocks. In fact, the fund's shareholders dip into capital when they cash their checks, but such dipping is obscured by the dividend label on the checks.
Other mutual fund companies, such as Vanguard and Fidelity, offer funds that convert capital to income. The conversions are transparent and violations of the don't-dip-into-capital rule are also transparent. Vanguard's Managed Payout Funds offers three funds, paying 3 percent, 5 percent or 7 percent each year. Vanguard states that money for these payments will come from income, including interest and dividends, as well as from capital, including capital gains and capital itself.
Retirees in search of income prefer such opaque dips into capital to no dips at all. It's a practical solution: The mental accounts prevent us from raiding our capital but the dips allow us to live slightly better.