MENTAL ACCOUNTING

 

Mental Accounting is Thaler's theory according to which individuals possess a psychological accounting system that violates several axioms of classical economic theory by influencing choices in a relevant way.

 

An example is given by the "system of accounts" according to which individuals organize their choices relating to income and savings with a system of real mental accounts, violating the economic principle of fungibility of money:

• a mental account for current expenses

• a mental account for savings  related to exceptional expenses (e.g. buying a new car)

• a mental account for long-term investments (e.g. retirement purposes)

The system of accounts, whether managed through Excel sheets, notebooks, envelopes or jars, can be very useful for controlling expenses; in fact, each account corresponds to a different propensity to consume, thus allowing to strengthen the capacity for self-control and therefore savings.

Thaler's work also analyzes how people manage  mentally the gains and losses:

• Integrated mental account

in this case they use a single general mental account in which they account for all the operations carried out in a certain period. The balance is represented by the difference between gains and losses.

• Separate mental accounts

in other cases they use two separate mental accounts: in the first they account the earnings and in the second the  losses.

 

Investors and the effects of separate mental accounting

• Separate mental accounting can generate in investors a distorted perception of the performance of their portfolio by focusing attention  on the performance of individual securities, rather than on the overall trend.

In a very simplified situation where an investor only owns two stocks, one losing and one in profit, the separate valuation of their returns may lose sight of the fact that the portfolio's return is still positive.

Furthermore, the perception that the portfolio is in loss could be accentuated by the fact that according to the Prospect Theory the losses are “felt” twice as much as the gains.

 

• Separate mental accounting can also cover portfolio allocation.

In a 2001 study, Benartzi and Thaler offered participants several options regarding the allocation of savings and observed the following:

• when two funds are available, the first invested in shares and the second invested in bonds, people invest half of their savings in the first fund and half in the second

• when, on the other hand, three funds are available, two of which are equity and one bond,  savers divide their savings equally between the three funds (heuristic 1 / n) thus building a portfolio consisting of two thirds of shares and one third of bonds; therefore, investors value the three options separately and not as parts of the same portfolio.

The inconsistency and thus the effect of mental accounting is highlighted in the fact that if in the initial situation with only two available funds, individuals decide to invest half of their assets in the equity fund and the other half in bonds, then also in the subsequent situation they should make up a portfolio consisting of fifty percent shares and fifty percent bonds,  regardless of the number of options available.

Following the heuristic mentioned above, however, we arrive at an allocation in which the portfolio is composed of 66% of equities.