In today’s highly competitive environment, advisors are employing various client-profiling tools to understand more about their clients’ needs. Some have embraced a more comprehensive financial planning process; others have pioneered the concept of “life planning.” By understanding and using another tool–the science of behavioral finance–you may be able to understand your clients at a still deeper level and serve them even better.

In this article we will explore a concept called “mental accounting.” We’ll give you some ideas about how mental accounting works and how to use that understanding to raise the level of service you offer your clients.

Mental Accounting: The Concept

In 1738, Daniel Bernoulli promoted the idea that people make economic decisions based on the impact those decisions will have on their overall state of wealth. He believed people look at the big picture when making decisions about how to invest their assets. Great theory, but Bernoulli was wrong. Instead of looking at the big picture, people tend to mentally compartmentalize their assets into different “buckets,” and they manage each bucket independently. They tend to lose sight of the fact that each bucket is part of their overall wealth. They may even have different attitudes and risk tolerances toward these separate mental asset pools.

A study was conducted on how people allocate their assets in their company’s retirement plans. In plans that did not include company stock as an option, people allocated about 49% of their assets to equities and 51% to fixed income. In plans where company stock was an option, people invested 42% of their assets in company stock. They divided the remainder evenly between the other equity options and the fixed-income alternatives. The result was that in plans that offered company stock, the equity allocation was about 71%, compared to 49% for plans that did not offer company stock. Clearly, plan participants put company stock in a different “mental account” from the rest of their plan assets. They then allocated the remainder in the same way participants in plans without company stock had done.

The “dividend puzzle” provides another example of mental accounting. In 1958, Modigliani and Miller showed that in an efficient market with no taxes, a company’s dividend policy is irrelevant. However, because dividends are taxed at a higher rate than capital gains, shareholders actually fare better if their companies repurchase their shares rather than pay dividends. Yet many companies pay dividends and many investors are attracted to stocks that pay dividends.

Meir Statman, a prominent behaviorist, cites the example of shareholders who actually cried at Con Edison’s 1974 annual meeting when it eliminated its dividend during the 1973-74 energy crisis. Statman explains that these shareholders probably maintained dividends and capital in separate mental accounts. Elimination of the dividend created a “loss” in the dividend account and shareholders reacted negatively, even though they may actually have been better off. According to Statman, the rational investor will create his “homemade dividend” by selling shares. A “real-life investor” who has decided to be a “consumer only from dividends, but not dip into capital” may experience a significant amount of anxiety from violating the “rules.”

If you think about it, you will find that most of your clients maintain many different “mental accounts.” They are likely to have at least one taxable investment account, a retirement account such as a 401(k) plan, an IRA or two, and perhaps a number of custodial accounts for their children. They may also have a house, a whole life insurance policy with cash value, shares of low-basis stock inherited from a family member, a checking account for current expenses, and a vacation savings account. Your clients’ overall wealth may comprise separate components, each maintained by the client in a separate mental account.

How can you use this information to provide better service to your clients? Let’s take a look.

Client Profiling

The typical client-profiling process attempts to capture information about three key variables–return goals, risk tolerance, and time horizon–to allow advisors to develop and implement an appropriate investment strategy for the client. Based on this information, advisors craft portfolios.

This, however, is a flawed process. First, which risk tolerance are we measuring? Is it clients’ tolerance for risk in their taxable investment accounts or retirement accounts or their children’s custodial accounts? Behavioral finance teaches that clients are very likely to have different risk profiles with respect to different mental accounts.

Clients’ mental accounts are actually a reflection of a more complex profile than we consider in the typical profiling process. G. Scott Budge, a psychologist and investment professional, states that a client’s system of mental accounting is often part of a “family logic” developed to help families work through financial and investment issues. In its early stages, a family is most concerned with financial security. Then family legacy issues arise, such as how much and in what form wealth should be passed to children and grandchildren. Later, issues of social capital arise, such as how much and in what form wealth should be passed to charity. Clients’ attitudes and risk tolerance for each mental account may change over time depending on what lifecycle stage the client is in.

A better profiling process should explore what Budge calls “asset attachments.” Clients’ psychological interactions with their assets can be complex. It is common for clients to maintain inherited assets in a separate mental account and resist efforts to integrate those assets into an overall asset allocation strategy. Budge also provides the example of obsessive-compulsive individuals exhibiting depressive behavior who will ride bad stocks down and sell winners too early in order to confirm their beliefs about themselves as losers. He also points out that hysterics may develop strong, personalized relationships with a stock, as if the stock knows that they own it and is acting accordingly. These are extreme examples, but they demonstrate the importance of profiling clients’ attitudes and investment behaviors in a way that goes beyond the customary “risk/return/time horizon” format.

While it is beyond the capabilities of most advisors to probe for evidence of psychological disorders, advisors can explore the nature of each client’s “family logic,” “asset attachments,” and mental accounting system. Try to discover the range of long-term and short-term goals the client associates with each mental account–not the return goals, but the life goals such as retirement, educating children, or buying a second home. Ask questions about the risk tolerance the client has with respect to each mental account.

Clients may naturally maintain mental accounts, but that does not mean that advisors should be passive in dealing with them. Encourage clients to view their separate mental accounts as part of their overall state of wealth and help them focus on the forest rather than the trees.

Managing Risk Tolerance

Every day, advisors face the question of what to do with clients who need to invest aggressively to meet their return objectives, but have a low tolerance for risk. The issue would be easier to solve if you could reduce the anxiety some clients experience during volatile markets.

Behavioral finance teaches that clients tend to be disproportionately loss averse. We also know that investors compartmentalize their investments into mental accounts, which means they independently determine whether those accounts are winners or losers. In the worst cases, investors may even judge the individual investments in these accounts as winners and losers on a continuous basis. This is what behaviorists call “narrow framing.” Investors who look at their portfolios this way are in for a lot of pain. By encouraging them to adopt a broad frame of reference, you can reduce their anxiety.

Agree with your clients up front that the basis for judging the success of their investment program will be to look at the progress they are making toward their overall financial objectives. Translate their financial objectives into a dollar amount to be accumulated within a given number of years. For example, “I need to have $1 million in liquid assets in my portfolio by the year 2017.” Translate that goal into a target amount you want to have in the portfolio at the end of each year. Compare the client’s actual performance only to his or her personal financial objectives. Don’t look at annual rates of return, performance relative to indexes, or the performance of the components of the client’s portfolio. Use consolidated performance reports whenever possible to focus attention on aggregate returns, not the returns of each mental account or the individual investments comprising the account. Incorporate this approach into the client’s Statement of Investment Policy (SIP).

Asset Allocation

A well-defined asset allocation strategy can help clients transcend their narrow system of mental accounts and adopt a broader frame of reference. By its nature, the asset allocation process takes the overall portfolio into account and encourages us to look at the relationships that our assets have to each other. Thus, when building portfolios using Modern Portfolio Theory, we consider our assets part of a unified whole rather than as a series of unrelated investments.

By understanding mental accounting, an advisor can also be more effective in designing asset allocation strategies. For example, we already know many clients with company stock in their retirement plans do not view that stock as a part of their allocation to equities. As a trusted advisor, you can help clients eliminate this particular mental account and put the company stock in the equity “bucket” where it belongs.

Similarly, we can be sensitive to the fact that clients may maintain inherited assets in separate mental accounts from their other assets. When you try to get a client to liquidate a large position of stock in “Grandpa’s company,” you should anticipate a different reaction than if you were recommending the sale of a stock that the client maintains in a different, less emotionally charged, mental account.

Asset allocation can also help clients with the issue of regret. When clients initially agree to allocate defined portions of their assets to specific asset classes, they are reducing the number and magnitude of the investment decisions they will need to make in the future. For example, when the large domestic growth asset class takes a dive, the client’s anxiety is reduced because he or she did not make a choice to “bet” on large growth, it was simply an outgrowth of the overall investment policy.

Issues of Self-Discipline

Do any of your clients have trouble saving for retirement? If so, mental accounting may be partially to blame. A study done by Bernheim, Skinner, and Weinberg in 1997 concluded that most people do not increase their level of saving significantly as retirement approaches. Instead, new retirees dramatically lower their level of consumer spending for about two years. The study suggests that most people divide their wealth into mental accounts that include a “regular income account,” “liquid assets,” “home equity,” and “future income.” Then they gear their consumption to the income account. They do not increase savings as retirement draws near because they have not experienced an impact in their income account yet. When they do, it is too late to save so they decrease consumer spending.

Hersh Shefrin, another prominent behaviorist, describes saving as a problem of self-control. He suggests that the best way to counter the problem noted by Bernheim, Skinner, and Weinberg is to routinely divert money from the income account into an account that is viewed as off-limits, such as a 401(k) account or IRA. This may involve agreeing with your client to impose a rule like “pay your retirement account before you pay yourself.”

To conclude, clients these days want someone who understands them–someone who understands their needs and can tailor a plan to meet those needs. Behavioral finance offers a way for advisors to better understand client needs and respond with personalized, customized advice. When you give your clients more of what they want, you become a more capable and competitive advisor.