The Inefficiency of Mental Accounts, Bucketing, and Goals-based Investing

Abstract

Goals-based investing frequently treats each goal independently and constructs each corresponding portfolio in isolation. Beyond the possible efficiency losses caused by the self-imposed constraints of a mental accountingoriented bucketing approach, we argue that omitting non-tradable constituents of a holistic economic balance sheet, such as human capital and liabilities, can significantly impact the efficiency loss from a balance sheet perspective. We quantify the efficiency losses across a wide variety of possible combinations of risk aversion, varying human capital assumptions, and financial capital levels. We find efficiency losses in all cases, a high of 148 basis points, and primarily attributing efficiency losses to a disconnection among starting financial capital, riskiness of human capital, and risk aversion.

Sebastian Gomez-Cardona

Director of Research

I am Director of Research in Investment Advice and Planning at Morningstar Retirement.