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Example 1: Imagine that you are about to purchase a jacket for $125 and a calculator for $15. The salesman informs you that the calculator you wish to buy is on sale for $10 at the other branch of the store, located a 20-minute drive away. Would you make a trip to the other store?
Example 2: Imagine that you are about to purchase a jacket for $15 and a calculator for $125. The salesman informs you that the calculator you wish to buy is on sale for $120 at the other branch of the store, located a 20-minute drive away. Would you make a trip to the other store?
As you might have guessed, 68% answered “Yes” to Example 1, while only 29% answered “Yes” to Example 2.
Although these experiments were conducted in 1984, they are still relevant in today’s world. They gave us a glimpse of the irrationality in our brains. In the examples above, the differences in behaviour can be attributed to a quirk in human behaviour called “mental accounting”. This is the tendency for humans to make our decisions in silos rather than on the aggregate.
In both examples, the overall savings for the 20-minute ride is $5. But where people perceived the $5 discount coming from affected their decision – whether it is $5 off $125, or $5 off $15.
If you are asking how this affects your life, the answer is “probably more than you know”. Consider the following experiment designed by the 2017 Nobel Laureate Richard Thaler.
Example 3: Mr. and Mrs. J have saved $15,000 toward their dream vacation home. They hope to buy the home in five years. The money earns 10% in a money market account. However, they just bought a new car for $11,000 which they financed with a 3-year car loan at 15%.
Essentially, Mr. and Mrs. J borrowed $11,000 at 15% and then reinvested it at 10% through their savings, effectively structuring a deal with a guaranteed loss of 5%. If they just used the money they already saved for the holiday to buy the car, they wouldn’t be in this situation.
Brain malfunctions affect all our senses, from vision (white-gold or blue-green dress?) to auditory (Yanni or Laurel?) to touch. You probably did a science experiment in Primary 3 that involved putting the left hand in warm water and the right in cold water.
When you put both hands in lukewarm water, the temperature felt different to each hand even though they were both in the same bucket of water.
It should come as no surprise that this also affects how the human brain thinks. The latest findings in behavioural economics and finance research shows us why rational human brains malfunction.
Brain malfunctions are often predictable. Different humans are apt to commit the same kinds of mistakes again and again. Even if we are aware of a specific problem and have verified it, it will still capable of casting an illusory spell on us.
An example of this is the optical illusion below. Even if this is the tenth time you see this picture, your brain still falls into the same trap and thinks that the black dots in the intersections are turning white only while you’re staring at it.
The point is, your best defence against mental accounting biases isn’t simple. You will need exposure to a wide range of biases and their different permutations, and on top of that, be ever vigilant because we are programmed to fall into these traps again and again.
Let’s examine one solution to this mental accounting bias. The following example is a very common situation among Singaporeans, but poor communication has led to decreased policy effectiveness.
Example 4: In 2008, a newlywed couple used $100,000 from their CPF accounts to pay for a HDB flat, and borrowed the remainder from a bank. When they sold the flat in March 2018, they were prepared to return the $100,000 to their CPF accounts.
However, they were shocked to find out that they also have to pay back the accumulated interest on this $100,000 over the period of 10 years, at an interest rate of 2.5%.
People who found themselves in this situation often wonder why they need to pay back the interest. If the CPF funds belong to us, their argument goes, why do we have to pay interest to use it?
At this point, hopefully you have realised that this is the mental accounting bias. The policy’s intent is to guide home-buyers into thinking holistically about their home purchase, and consider all their available finances, including their CPF funds.
Most people treat their CPF savings as something they can just dip into without consequences, but the very real result of withdrawing those funds from your OA is causing you to lose 2.5% of interest per year. Even if those funds are going towards financing an asset like your home.
By mandating the payback of the owed interest, one intent of the policy is to remind home-buyers to mentally account for CPF money as part of their overall savings.
Those who have studied Corporate Finance will be familiar with the term “Cost of Capital”. This refers to the opportunity cost of funds. Each source of money represents a different investor or creditor, and having provided this money to the firm, this rate normally defines the minimum required rate of return for their sources of funds.
Illustrating with the HDB flat example, let’s say a couple sets up a company to buy a HDB flat worth $250,000. The money could potentially come from various sources. At the point of purchase, the couple has $90,000 liquid cash in their bank savings accounts (after accounting for 6-month emergency funds), $10,000 in fixed deposits, $60,000 in their stock portfolio, and $100,000 in their CPF OA funds.
The couple also has access to flexible bank mortgages at a floating interest rate of roughly 1%, or a HDB loan at a flat 2.6% interest rate. They don’t know it, but they are the CFOs of this small company, and they are implicitly choosing the capital funding structure. They decide on the cost of capital by the way they choose to pay for their flat.
It is easy to see that each potential source of funds comes with it an attached interest rate. One of the first decisions of any CFO is the amount of debt to use. In this case, the couple can choose to max out their loan, or fund the flat fully out of their pockets. Most people end up choosing a point somewhere in between.
In choosing the debt burden, a related decision is choosing the equity sources. They also have to decide how to fund the remaining equity. Whereas the interest rates of debt are easy to observe, interest rates of their equity lines are not. Banking accounts are earning nearly 0% interest, stock portfolios could be earning 8% compounded annually, and the CPF-OA is earning interest at 2.5%.
One way a prudent CFO decides is to choose the funding sources with the lowest required rate of return. In this case, dormant funds in the savings account should be considered first, before the CPF-OA funds, which comes before the stock portfolio.
Essentially, this is what the CPF housing accrued interest tries to remind people of. Had they decided to use the funds in the stock portfolio which was earning 8% annualized returns, then at the sale of the HDB flat, the proper thing to do is to return 8% accrued interest to the stock portfolio.
If this hidden rule was made more apparent, and enforced diligently, more people will think twice before using their retirement stock portfolio to fund their flat.
If you’ve read this far, you would probably be interested in actionable advice. The first step is to recognise mental accounting whenever it occurs, like when your friend is boasting about a vacation fund in a savings account earning near 0% while at the same time having credit card debt piling up at 20%.
In general, it would be best to think of decisions at the aggregate portfolio level, whether you are funding a new HDB flat purchase or a new car. Sometimes it’s not that obvious which line of thinking is right or wrong, such as in the first two examples. In these cases, the best antidote is to adopt a habit of reframing every decision at the aggregate level.
Where applicable, it is helpful to think of the opportunity cost associated with each pot of money. When you use money from a pot and have to pay back its respective interest, you will automatically be more prudent in selecting from the pot with the lowest opportunity cost.