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BF/U2 Topic 4 Mental Accounting

Mental accounting was proposed by Richard Thaler. Traditional finance holds that wealth in general and money in particular must be regarded as ‘fungible’ and every financial decision should be based on rational calculation of its effects on overall wealth position. In reality, however, people do not have computational skills and will power to evaluate decisions in terms of their impact on overall wealth. So people separate their money into various mental accounts which has different significance to them.

Mental accounting describes the tendency of people to place particular events into different mental accounts based on superficial attributes (Shiller, 1998)52. People separate money and financial risk into ‘mental accounts’ putting wealth into various buckets. They place their money into separate parts on a variety of subjective criteria, like the source of money, and intend of each account, which has an often irrational and detrimental effect on their consumption decision and other behaviours. For example, investors may feel free to take risk in their own account rather than their children.

Mental accounting manifests itself in investors’ behaviour in following ways:

  • Investors have a tendency to ride losers as they are reluctant to realize losses. Mentally, they treat unrealized ‘paper loss’ and realised ‘loss’ differently, although from a rational economic point of view they are same.
  • Investors often integrate the sale of losers so that the feeling of regret is confined to one time period.
  • Investors tend to stagger the sale of winners over time to prolong favorable experience.
  • People are more venturesome with money received as bonus but very conservative with money set aside for children’s education.
  • Investors often have irrational preference for stocks paying high dividends, because they don’t mind spending the dividend income, but are not inclined to sell a few shares and ‘dip into the capital’.

So, ‘mental accounting’ refers to how individuals mentally integrate different parts of their wealth. Even over monitoring of portfolio is the result of this biasness. That reflects the way in which investors assign sums of money to different actual or notional accounts for different purposes with varying degrees of risk tolerance upon the importance of achieving the particular objective.

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