A client of mine was paid in US dollar. He asked me whether should he maintain a US dollar saving account and accumulate his saving there as he receives the US salary. The rationale is because of the declining US, he hopes it will “recover” in the future. If he converts all the money into SGD now, there is no “hope” of recovering.

My response to that was quite simple: There are two risks experience by this person. Firstly, his income is subjected to the risk of the US declining. So every time the USD drops, he will suffer a pay cut. Another one is that if the saving account is in USD, then all previous pay already received continues to be subjected to the same risk of USD declining. Moreover, if the saving account is meant for “saving” purposes, then there must not be any risk in the first place. Thus, currency risk is unacceptable.

In financial jargon, my client’s question is what we call “mental accounting.” In the above example, the person thinks that as long as the asset has not be sold (in this case if the US dollar has not be converted to SGD), there is only “paper losses.” In reality, there is no such thing as paper losses for asset that is highly liquid. Paper losses and real losses are the same thing. The reason is because the market value of the asset can be accurately ascertained due to its high liquidity. If the asset must be sold urgently, the “paper losses” and real losses are exactly the same in value. This is unlike non-liquid asset like property in which paper losses are merely an estimate. The value of real losses can only known unless a successful transaction between a buyer and seller has been made.

Mental accounting does manifest itself in the way many people make their decisions – most of which are illogical and to certain extend foolish. Sometime in order not to embarrass my clients, I’ll not correct their mistake. In addition to the above, here are more examples of mental accounting in action:

1. Client does not wish to sell the losing money unit trust because the unit trust is losing money. [Investment decision should be based on asset allocation and future possibilities, not past performance. Past performance has no influence over the future]
2. If the portfolio earns Y%, client wishes to withdraw this Y% and then in doing so “resets” the portfolio to the beginning. [Making withdrawal does not influence the IRR of the portfolio. In fact, it decreases the IRR because of additional sales charge when the client wishes to top-up the previously withdrawn money.]
3. Looking at the individual funds rather then the totality of the portfolio. [Actually it does not really matter how much each fund earns or lose. The total portfolio return is more important.]
4. Client wishes to invest in a high dividend fund/portfolio in order to enjoy the dividends without touching the capital. This is the same as number 2. Many unit trusts give dividends but in reality it actually sell some securities to give out that payout. To me that is very costly for each selling of securities incurs brokerage charges.