What would you do with an extra £100 in wages each month? Would you save it or spend it? How about a £1,200 bonus? You may well be more inclined to spend the wage increase and save the bonus, and that would not be unusual.
In 1980, Richard Thaler described how individuals place identical sums of money in different mental accounts depending on where they came from (wages, bonuses) or what use was planned for them (weekly food shop, holiday). Accepting that you may be thinking about your money in this way is important when you plan your investments.
Modern Portfolio Theory s a mathematical framework that takes the expected return and risk profile for multiple investments, and the relationship of price movements in each compared with all the rest. The data is used to find a portfolio with the highest expected return for a given level of risk. The task becomes more difficult as the number of investments increases, and all your money is treated identically in the portfolio.
Financial institutions may use this approach, but an individual will probably find it daunting. Also, having one portfolio that represents all your wealth in theory, but in practice is divided into say a savings account, and an ISA and SIPP (which themselves hold multiple investments), may be difficult to manage. Watching one account that you have earmarked to buy a new car declining, while another goes up is going to be demoralising, no matter if your portfolio is doing just fine overall.
A goal, which could be anything from a pension pot to a wedding fund, will be met by having an amount of money at a certain point in time. Each goal gets its own cash and investments to back it, which allows for money to be treated differently depending on where it came from and what it is for. This approach does not fight with our mental accounts and is more in tune with how we plan for the future.
Risk is framed as the probability of not meeting a goal, with goals that are essential needing a high probability of being met, and a lower chance of success being acceptable for aspirational goals. As an example, you may need a certain amount of money for retirement, so you work out how much you need to save each month (before pension contribution tax relief) and deposit it into a SIPP. You hold this money as cash or in a UK money-market fund because you want a high chance of hitting your target.
However, you would certainly like more money in retirement so you invest the rest of your budget in a UK government bond fund, and if you receive unexpected amounts of money that can be put away for retirement, then perhaps they buy into a fund that tracks the FTSE 100 Index. Retirement needs are highly likely to be met, but there is also a chance of having a little or a lot more.
What goals you have and what investments support them are up to you, but having confidence and understanding your plan — even if it passes up the chance of more money for increased certainty for less, or is not considered optimal or efficient — makes it easier to stick with.
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James J. McCombie has no position in any of the funds mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.