Mental Accounting

1. Mental Accounting Bias Description

Mental accounting describes people's tendency to code, categorize, and evaluate economic
outcomes by grouping their assets into any number of non-interchangeable (mutually exclusive)
mental accounts.
It is irrational to treat various sums of money differently based on where these sums are mentally
categorized.
For example, how a certain sum has been obtained (work, inheritance, gambling, bonus, etc.) or
the nature of the money's intended use (leisure, necessities, etc.).
Money is money, regardless of the source or intended use.
Adding the concept of framing is important in mental accounting analysis. In framing, people
alter their perspectives on money and investments according to the surrounding circumstances
that they face.
Mental accounting can cause a variety of problems for investors. The most basic of these
problems is the placement of investment assets into discrete “buckets” according to asset type,
without regard for potential correlations connecting investments across categories.
Tversky and Kahneman contended that the difficulty individuals have in addressing interactions
between investments leads investors to construct portfolios in a layered, pyramid format. Each
tier addresses a particular investment goal independently of any additional investment goals.
For example:
When one of your objectives is to preserve wealth, investors tend to target low-risk
investments, like cash and money market funds.
For income (as an objective), they rely mostly on bonds and dividend-paying stocks.
For a chance at a more drastic reward, investors turn to riskier instruments, like emerging
markets' stocks and initial public offerings (IPOs).
Combining different assets whose performances do not correlate with one another is an important
consideration for risk reduction, but it is often neglected in this “pyramid” approach.
People quite often fail to evaluate a potential investment based on its contribution to overall
portfolio return and aggregate portfolio risk; rather, they look only at the recent performance of
the relevant asset layer.
This common, detrimental oversight stems from mental accounting.

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1.1 Mental Accounting Bias: Behaviors That Can Cause Investment Mistakes
1.1.i Mental accounting bias can cause people to imagine that their investments occupy separate
“buckets,” or accounts.
These categories might include, for example, college fund or money for retirement. Envisioning
distinct accounts to correspond with financial goals, however, can cause investors to neglect
positions that offset or correlate across accounts. This can lead to suboptimal aggregate portfolio
performance.
[Link] Mental accounting bias can cause investors to irrationally distinguish between returns
derived from income and those derived from capital appreciation.
Many people feel the need to preserve capital (i.e., principal) and prefer to spend interest. As a
result, some investors chase income streams and can unwittingly erode principal in the process.
For example, a high-income bond fund that pays a high yield yet, at times, can suffer a loss of
principal due to interest rate fluctuations. Mental accounting can make instruments like these
appealing, but they may not benefit the investor in the long run.
[Link] Mental accounting bias can cause investors to allocate assets differently when employer
stock is involved.
Studies have shown that participants in company retirement plans that offer no company stock
as an option tend to invest in a balanced way between equities and fixed income instruments.
However, when employer stock is an option, employees usually allocate a portion of
contributions to company stock, with the remainder disbursed evenly over equity and fixed-
income investments.
Total equity allocation, then, could be too high when company stock was offered, causing these
investors’ portfolios to potentially be under-diversified. This can be a suboptimal condition
because these investors do not fully comprehend the risk that exists in their portfolio.
[Link] Mental accounting bias can cause investors to cease in to the “house money” effect,
wherein risk-taking behavior escalates as wealth grows.
Investors exhibiting this rationale behave irrationally because they fail to treat all money as
exchangeable. Biased financial decision making can, of course, endanger a portfolio.
1.1.v Mental accounting bias can cause investors to hesitate to sell investments that once
generated significant gains but, over time, have fallen in price.
During the bull market of the 2000s, investors became accustomed to healthy, unrealized gains.
When most investors had their net worth deflated by the market correction, they hesitated to sell
their positions at the then-smaller still unrealized profit margin.
Many today still regret not reaping gains when they could; a number of investments to which
people clung following the boom have become nearly worthless.

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2. Mental Accounting Bias Practical Advice
2.i Correlations between Investment “Buckets”
Demonstrate how investments identified with separate mental accounts can actually correlate
with one another, impacting portfolio performance.
A straightforward discussion of the harms of excessive correlation and the benefits of sufficient
diversification ought to effectively refute the bucket rationale. Since mental accounting is a
cognitive bias, education can often defeat it.
[Link] Total Returns as Priority
Remind and educate your client that total returns are, after all, the number-one priority of any
asset allocation.
As clients become more conscious of total returns, they will likely recognize the pitfalls of
excessive mental accounting, and the problem will remedy itself.
[Link] Company Stock and Diversification
Persuading clients to diversify away from company stock is indeed a recurring theme.
The client must be educated as to the benefits of a balanced, diversified portfolio.
Excessive concentration in any stock is not good, but a variety of behavioral biases can crop up
and cause investors to feel irrationally comfortable with their own companies’ stocks.
[Link] House Money Effect
The house money effect is a manifestation of mental accounting that can cause people to take on
more risk as their wealth increases.
Education can help clients overcome it. Gentle but straightforward reminders regarding the risk
of a chosen investment or the exchangeability of money in general can diminish the house money
effect.
The house money effect causes investors to devalue a dollar as aggregate dollars accumulate.
They sense that they are now playing with the “house’s” money, not their own.
Dollars won or found seem, for many people, irrationally expendable. Therefore, it is crucial to
stress the underlying truth that a dollar equals a dollar no matter which mental account each
dollar occupies.
2.v Clinging to Formerly Gainful Investments
Unfortunately many people have short memories.
If a company's prospects today do not look good and if it is still possible to divest from that
company and capture a gain, then the client should evacuate the position immediately.
The investment may have generated great profits in the past, but most clients should rationally
grasp that the present-day outlook matters most.
A convenient reminder is: “No one ever got hurt taking a profit.”

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3. Mental Accounting Bias Diagnostic test
Question 1—Part A
Suppose that you are at a warehouse store, where you intend to purchase a
flat screen television. The model you've selected is priced at $750, and you
are about to pay. However, at the last minute, you notice a discarded
advertising flier featuring the same television—at a price of $720. You
retrieve the ad, examine it more closely, and discover that the offer is still
valid. To receive the discount, you'll need to drive to a competing
electronics outlet about 10 minutes away.
Will you get into your car and travel to the other store to take advantage of
the lower price?
a. Yes.
b. No.
Question 1—Part B
Now suppose that you are in the same warehouse store, this time to buy a
mahogany table. The table that you want costs $4,000, and you are willing
to pay. While you are waiting, you strike up a conversation with another
store patron, who reveals that she's seen the same table available for $3,970
at a competing local furniture store about 10 minutes away.
Will you get into your car and drive to the other store to obtain the lower
price?
a. Yes.
b. No.
Question 2—Part A
Suppose that you have purchased a ticket to a concert by your favorite
music artist. You arrive at the venue excited, but quickly panic as you
realize that you have misplaced your ticket! You paid $100 for the ticket
initially and discover that some similar seats are still available at the same
price.
What is the probability that you will purchase another $100 ticket in order
to see the show?
a. 100 percent.
b. 50 percent.
c. 0 percent.

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Question 2—Part B
Suppose that you have not purchased any concert tickets in advance but
planned to buy one for $100 at the door. When you arrive at the box office
to buy your ticket, you panic because you realize you've lost $100 on the
subway en route to the show. There is an ATM close by, so you can still
get cash and purchase a ticket.
What is the probability that you will make a cash withdrawal and then
purchase a ticket for $100 to see the show?
a. 100 percent.
b. 50 percent.
c. 0 percent.
Question 3—Part A
Suppose that you've taken half a day off work to shop for a new, ride-on
lawn mower. You have a big yard, and trimming it with your current, push-
propelled mower simply takes too long. You have been eyeing the Model
A300, which offers all the features you require at a cost of $2,000. As luck
would have it, you won $500 the previous evening playing bingo at your
local Rotary Club. When you arrive at the lawn mower shop, you notice
that they also stock Model A305, which has some fancy, desirable new
options. This premium model costs $2,250.
Considering the previous night's winnings, what is the probability that you
will indulge yourself by purchasing the A305?
a. 100 percent.
b. 50 percent.
c. 0 percent.
Question 3—Part B
Suppose that your budget and your needs regarding the lawn mower are
exactly as described in Question 3A and that again you've taken half a day
off work to go buy the simpler-but-sufficient A300. However, imagine that
while you've not been especially lucky at bingo, you do discover a $500
check in your jacket pocket. You recall that the money was a gift from your
mother last year, something to be “put away for a rainy day.” You
apparently forgot that you put it in your jacket and have just come up on it.
When you arrive at the lawn mower shop, you again notice the pricier A305
for $2,250, with its coveted, innovative mowing features.
Considering the check you just found, what is the probability that you will
go ahead and purchase the A305?
a. 100 percent.
b. 50 percent.
c. 0 percent.

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Test Results Analysis
Question 1—Parts A and B
Most people would probably drive an extra 10 minutes to save $30 on the
television but wouldn't go to the same trouble to save the same amount of
money on the table.
While both scenarios net a savings of $30, a typical mental accounting
scheme doesn't envision things this way.
So people who are more likely to go out of their way to receive a discount
in Part A than in Part B are likely susceptible to mental accounting bias.
Question 2—Parts A and B
If the respondent is like most people, he or she answered “no” to the first
question and “yes” to the second, even though both scenarios present the
same prospect: an initial loss of $100, an additional $100 outlay for the
ticket.
Mental accounting causes people to perceive in the first scenario an
aggregate cost of $200 for the show—two tickets, each costing $100.
Conversely, for most people the loss of $100 cash and the additional $100
ticket price are somehow separate in the second scenario.
Mentally, these sums are debited from two independent categories or
accounts, meaning that no single, larger loss of $200 ever registers.
In both cases, of course, the concert costs $200. If the respondent indicated
a greater willingness to pay for a ticket in Part B than in Part A, then mental
accounting bias is likely present.
Question 3—Parts A and B
Most people would answer “yes” in Part A and “no” in Part B. They would
be willing to allocate the bingo winnings but not the check from mom
toward the purchase of the premium lawn mower.
This is because most people engage in mental accounting.
In this instance, mental accounting values dollars obtained from different
sources differently.
However, money is indeed fungible. Responses demonstrate that this all-
too-typical inconsistency between Parts A and B probably indicates mental
accounting bias.

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