Quick: What if I gave you $1,000 to invest however you wanted right now? It’s your money now – free. Would you put it on a speculative option play and try to double it within a week?

Now, ask yourself, would you be likely to make the same speculative decision if forced to use your own money to make a trade? Probably not. The answers to these questions help illustrate the main point of “Mental Accounting.”

Strictly speaking, we value earned money (especially if we had to work hard for it) more carefully than free money or ‘windfall’ profits. As such, we are more likely to take chances and speculate with free money, and we are more likely to preserve earned money. This, of course, makes intuitive sense but how does this affect your decisions in the market and how does it set you up for possible failure?

When you get a windfall profit you did not anticipate from a trade, you are elated and think you are a pro and want to put that money right back to work to make even more profits. It doesn’t take long before violating your money and risk management rules lead to that windfall profit dissapating like the dust in the wind.

On the flipside, when you only have a small amount of money to invest (especially if you worked hard at a job you didn’t enjoy), you are much more likely to guard that money with your life. This means (in the trading world) that you are more likely to wait for confirmation before entering, which not only may lead to missed profits, but missed opportunities. It only takes a few losses when trading with “scared money” for you to develop a heightened sense of fear before trading away your hard-earned dollars.

Going further, if you carefully research a company and charts before putting on a trade (with scared money), you enter when you are totally certain of reward and profit, yet the price goes against you. What do you do? You are losing money now, and it’s money you really can’t afford to lose. My guess is that you hold on to the position, knowing (hoping) that the price will reverse and you will still make a profit. However, the stock goes further against you. Do you sell?

Probably not. Now you hope to exit for break-even and at least get your hard-earned money back. Finally, you can’t take the pain of loss any longer and you sell. It doesn’t matter what the stock does next – you violated your discipline to cut losers short because you couldn’t afford to have a loss.

Valuing money differently leads to overtrading and excessive risk on one hand, and undertrading and holding on to losers too long on the other hand.

If you are interested in the academics behind Mental Accounting, a great resource is at www.behaviouralfinance.net

Next, I will discuss how to view money in the market and steps to reduce mental accounting errors.