The Role of Mental Accounting in Behavioural Finance

Mental accounting theory, introduced by Richard Thaler in 1999, is a behavioral economics concept that states that the importance of money and the impact each individual attaches to available funds is based on subjective criteria and can lead to irrational spending.

 

Whereas, Behavioral finance, a subfield of behavioral economics, proposes that psychological influences and biases influence investors' and financial practitioners' financial behaviors. Furthermore, influences and biases can be used to explain all types of market anomalies, particularly market anomalies in the stock market, such as sharp rises or fall in stock price. Because behavioral finance is such an important part of investing, the Securities and Exchange Commission has staff dedicated to it.

 

What is Mental Accounting?

 

Mental accounting refers to the various values a person assigns to the same amount of money based on subjective criteria, often with negative consequences. In the field of behavioral economics, mental accounting is a concept. It was developed by economist Richard H. Thaler and contends that people classify funds differently and thus are prone to irrational spending and investment behavior.

 

Richard Thaler, a professor of Economics at the University of Chicago's Booth School of Business, pioneered the concept of mental accounting in 1999. The concept was published in a paper titled "Mental Accounting Matters," in which Thaler explained how mental accounting causes people to make irrational spending and investment decisions. He defined mental accounting as a collection of cognitive operations performed by individuals.

 

Thaler emphasized the concept of fungibility in debunking the mental accounting theory. The idea is that all money is interchangeable and that people should treat all money the same, regardless of its intended use or origin.

 

Mental accounting is a description of consumer spending psychology in which they categorize and evaluate economic outcomes. The mental accounting theory addresses the various thought processes that go through consumers' minds when making spending decisions. The following are some of the most common aspects of consumer psychology.

 

The mental-accounting line of thought appears to make sense but is highly illogical. Some people, for example, keep a special "money jar" or similar fund set aside for a holiday or a new home while also carrying significant credit card debt. They are likely to treat money in this special fund differently than money used to pay down debt, even though diverting funds from the debt-repayment process increases interest payments, lowering their total net worth.

 

What is Behavioral Finance? 

 

The study of the influence of psychology on the behavior of investors or financial analysts is known as behavioral finance. It also includes the subsequent market effects. It focuses on the fact that investors are not always rational, that their self-control is limited, and that they are influenced by their own biases.

 

Behavioral finance can be studied from a variety of angles. Stock market returns are one area of finance where psychological factors are frequently assumed to influence market outcomes and returns, but there are many different perspectives to consider. Behavioral finance classification aims to help people understand why they make confident financial decisions and how those decisions affect markets.

 

Financial participants are assumed to be psychologically influential with somewhat normal and self-controlling tendencies in behavioral finance, rather than perfectly rational and self-controlled. Financial decisions are frequently influenced by the investor's mental and physical health. When an investor's overall health improves or deteriorates, their mental state frequently changes. This influences their decision-making and rationality in all real-world problems, including financial ones.

 

Behavioral finance, a subfield of behavioral economics, proposes that psychological influences and biases influence investors' and financial practitioners' financial behaviors. Furthermore, influences and biases can be used to explain all types of market anomalies, particularly market anomalies in the stock market, such as sharp rises or fall in stock price. Because behavioral finance is such an important part of investing, the Securities and Exchange Commission has staff dedicated to it.

 

For decades, psychologists and sociologists have argued against mainstream finance and economics theories, claiming that humans are not rational utility-maximizing actors and that markets are inefficient in the real world. To address these issues, the field of behavioral economics arose in the late 1970s, amassing a wide range of cases in which people systematically behave "irrationally." Behavioral finance refers to the application of behavioral economics to the world of finance.

 

The notion that psychology drives stock market movements contradicts established theories that advocate for efficient financial markets. Proponents of the efficient market hypothesis (EMH), for example, argue that the market quickly prices any new information relevant to a company's value. As a result, future price movements are arbitrary because all available (public and some non-public) information has already been discounted in current values.

 

Examples of Mental Accounting

 

Individuals who place each goal and the money intended for each goal in a separate mental account may fail to examine the dangers or correlations of mental accounts. Instead of viewing portfolios as a single entity, it may construct portfolios that look like a stacked pyramid.

 

Individuals use mental accounting to assign subjective values to their money. These values, however, contradict accepted economic principles. The concept of mental accounting is derived from behavioral economics. People frequently place different values on the same amount of money based on their preferences. However, this procedure may result in losses.

 

The following are some examples of Mental Accounting Bias:

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Examples of Mental Accounting

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1. Refunds of Taxes:

 

A tax refund compensates a taxpayer for any excess tax paid to the federal or state government. If a taxpayer receives a tax refund, it means they paid too many taxes during the previous fiscal year, resulting in an interest-free loan to the government.

 

The majority of taxpayers regard tax refunds as a bonus or windfall that has little impact on their annual budget. It is incorrect because tax refunds reflect money that belongs to the taxpayer, and the tax authorities only recover the amount of tax paid. Tax refunds, regardless of origin, should instead be treated as regular income.

 

2. Bonuses:

 

A bonus is a payment made on top of a person's regular salary. Bonuses are typically given to entry-level and senior-level employees as an incentive. Furthermore, corporations use incentives to recognize exceptional achievements or the achievement of certain milestones.

 

Employees view bonuses differently than they do regular pay. As a result, many employees waste their bonuses on unnecessary items such as cars, trips, expensive clothing, and so on. Such spending violates the principle of fungibility. Before spending bonuses on extravagant purchases, employees should consider what they could spend the money on instead — something more deserving of that money.

 

3. Lottery victories:

 

Lottery winners may spend their winnings on questionable items, only to justify their actions with the undeserved windfall. As a result, many lottery winners go bankrupt shortly after receiving their prize and spending it on frivolous items. If the winners' pre-win financial plan had been followed, they would have earned returns on their assets or incurred acceptable expenditures.

 

Mental accounting causes a behavioral bias that can influence individual decisions. The "two-pocket theory" is another name for it. People in mental accounting tend to categorize their money and place it in mental accounts. The classification could be based on where the money comes from or how they intend to use it.

 

Mental accounting can happen to anyone. It is, however, still avoidable. People who practice mental accounting can use deliberate planning to break bad financial habits. These may include developing budgets or planning for any unexpected income or gains.

 

Furthermore, people who suffer from mental accounting can see the big picture. They can perceive decisions in absolute rather than relative terms this way. Individuals can avoid the negative effects of mental accounting bias by employing all of these techniques.

 

Mental Accounting’s effect on Investment

 

Investors who have a set budget allocate a certain percentage of their earnings to investments. Because a mental investment account must be closed by paying money, a documented budget with a specific dollar amount increases the pressure to make these commitments. If, on the other hand, an investor does not set aside money for investments and instead invests the remainder, they tend to invest less.

 

Reinvesting profits increases a person's risk tolerance significantly. If a person spends $10,000 of their hard-earned money, they will be extremely cautious. However, if that $10,000 were converted into 20,000 through capital gains, the investor would almost certainly take unnecessary risks with the capital gains. People are willing to take excessive risks with capital gains because they consider them to be free money.

 

The spreads at which day traders enter and exit equities are frequently thin. After transaction fees and taxes are deducted, they frequently barely recoup the cost of their capital. Because the funds are designated for high-risk day trading investments, they are willing to pay the exorbitant fees associated with such trading.

 

After receiving large sums of money, people become extremely cautious. People who receive a large sum of money are more likely to invest in safe, low-yielding investments. Those who receive the same amount in monthly payments, on the other hand, are more likely to favor high-yielding equities investments. It would be prudent to divide the funds between the two investments. However, due to the Mental Accounting Bias that results from mental accounting, it is difficult to do the same.

 

Conclusion

 

In conclusion, For a variety of reasons, our mental accounting processes cause us to make poor financial decisions. All of these causes stem from the fact that people do not think about value in absolute terms. Instead, an object's value is relative to several other variables.

 

Mental Accounting Bias is present when investors select assets for their risky and safe portfolios. To protect the former from the negative effects of the latter, investors separate their safe portfolios from their speculative portfolios. Investing in speculative and risky businesses indicates that investors are willing to take a risk and have more money to lose.