La Cible

Current assets Current wealth Home equity Future income 22 lacible | Octobre 2015 FEATURE ARTICLE We are far more likely to spend current assets than the money classified as future income. That means that a sum transferred to a lower hierarchical level in the pyramid is more likely to be saved for the long term. For example, for certain people, it can be more beneficial to use a TFSA for retirement savings than an RRSP. Before suggesting this approach, however, it is important to ask how the client classifies the money invested in a TFSA in comparison to money invested in an RRSP. A client who plans to use the TFSA money "in the event of an emergency" has probably classified this asset in the "current wealth" account and will be far more likely to spend it than if it had been invested in an RRSP, which is seen as "future income." Income classification Income is also classified based on its source. People tend to use their salaries differently from unexpected cash or windfalls, such as a $20 forgotten last year in the pocket of a winter coat. Loss aversion In general, people are uncomfortable when certain accounts are in the red. This tendency not to close accounts in shortfall can lead to irrational financial decisions, such as taking irrecoverable costs into account when they should not be weighed in the balance. As we saw in the last edition, people use a reference point to assess the value of each possible result when they make financial decisions. This issue is dedicated to mental accounting and framing, two factors that have a big influence on the reference point used to make a financial decision. Mental accounting is a concept that describes the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities. 1 According to this theory, people create "mental accounts" for their expenses, assets and various sources of income. The theory of mental accounting, which was developed by economist Richard H. Thaler 2 of the University of Chicago, sheds light on people's tendency to assign a different value to money depending on its source or projected use. Budget items (mental expense categories) Grouping together expenses into categories, which allows people to allot the available funds to various priorities, serves as a self-control mechanism. An unexpected expense that is not assigned to a specific account may explain the accumulation of credit card debt, for example. Also, as we pointed out in the August 2015 edition of La Cible, the higher the debt, the less evident the increase. This is what is known as "decreasing marginal sensitivity." This effect is clearly illustrated by sentences such as "at this point…" or "a few dollars more or less isn't going to make a difference." Asset accounts The accounts seem to be classified based on the person's willingness to spend them. Everything that is considered as current assets – such as a chequing account – comes first. Then there are cash and near cash assets, which are considered "current wealth." In third place comes "home equity" and, bringing up the rear, "future income," which includes retirement savings and the value of human capital. BEHAVIOURAL FINANCE: MENTAL ACCOUNTING AND FRAMING 1 R.H. THALER, (1999) "Mental Accounting Matters," Journal of Behavioral Decision Making, Vol. 12, pp. 183–206. 2 R.H. THALER, (1985) "Mental Accounting and Consumer Choice," Marketing Science, Vol. 4, pp. 199–214.

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