Behavioral finance FAQ / Glossary (Mental)

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Dates of related message(s) in the
Behavioral-Finance group (*):

Year/month, d: developed / discussed,
i: incidental

Mental accounts / accounting / compartments

01/3i, 12i - 02/10i + see
house money, monetary illusion,
mental myopia
+ bfdef2

.

Keeping several money drawers
in the mind?

Counting some of them in a biased
way
?

Not seeing the broad money picture?

Definition (in economics)

Head or tail, toy money, vault money:

not the same money?


Mental accounting
, as studied by H. Thaler, is

to use separate criteria to value and to deal with our different
economic assets, transactions, situations or expectations.

We tend to separate them in different groups (accounts) according to
their origins and purposes.

One Euro

we own

One Euro

we earn

One Euro

we owe

One Euro

 we spend

0ne Euro

we invest

get often separated inside our mind as

* different Euros *

in * different accounts *

that we * value differently *

What might lead to that behavior?

Why several bags when going to the market?
Is some money more fragile or heavier than others?


Mental accounting can have its rationale,
but in most case it is a
counter-productive
mental bias, which results often from:

Oversimplification

For example neglecting or missing some calculation factors,
such as the transaction costs when spending or investing.

Or a subjective categorization of types of operations

For example comparing

* a type of spending to one's income
* and another type to
one's wealth.


It is a cognitive bias, a kind of framing, as to dispatch mentally the money
into separate mental accounts makes deal with them differently as if it

they did not belong to the same "fungible" pool of money.

A common example:
    income account / compartment
vs.

capital account / compartment

Son, never eat the family's capital.

Certainly, dad, I will just devour the gains!

As the most usual example people manage their money differently
according to its source
.

They do not use the same criteria:

To manage their capital (usually in a
   conservative way,
so as not to make
   dents in it).


To spend or invest their incomes (and also their

unexpected windfalls: see house money),

With their incomes and windfalls they tend to

* be more lavish (when spending it)

* or take more risk (when investing it)

To make a caricature, they have their money in two different
bags,
one tightly closed and the other one open to their impulses.

Other examples


Also, as investors, people

  might separate mentally

* their financial reasoning on new operations

*   from their overall financial situation / commitment /
   wealth.

might also self-entice themselves to gamble with the portion

of their wealth they consider to have easily obtained.

=> They take risks that they would not take if they took into account
      their future needs or their overall financial performance.

It is is a dent in the expected utility theory, which states that people take
more risks if they are (or feel) wealthier and less if they are poorer (*).

To perceive to be momentarily richer or poorer in just a side bag 
is a kind of myopia which distorts that utility function.

 (*) See wealth effect, although that effect is more related to spending.

The wealth effect could even be considered as reverse mental accounts:
any available money in the pond, whatever its volatility, is considered the
same money that is used to back the spending binge.

Can some types of mental accounts be rational?

Budgeting according to expected satisfactions.


We have seen above how mental accounts can be unwise, if we define them as
linked to the source of money.

But if we extend the definition of mental accounts, to cover also our spending
or investments that are related to anticipations, we can find situations
in which it might be more rational.

We could talk about forward mental accounts vs. backwards mental accounts.

While to divide one's wealth into several mental purses is often a bias 

(as an affective perception or an over-simple heuristic), on the other
hand
it sometimes helps investors to make their rational budget
arbitrage between
several goals / preferences, mostly
between
immediate satisfactions and long term ones
(see time horizon).

For example, it might be judicious to decide:

How much money to put aside and   how much to

spend now ("carpe diem"; enjoy today),

How much investment money to use for fun or  short term

risk taking

  and how much for serious long term
ventures
, etc.

Mental accounting and investment performance

Myopic accounting and flawed bottom line

An aspect of mental accounting, akin to mental myopia (see that phrase), is
that people often neglect to take into account all the elements
(i.e.
transaction costs, inflation...) to measure
precisely their real investment
performance
.

=> As a result they usually overestimate it.

For example

They generally stay anchored on the rawest / myopic figures,

such as the buying price while neglecting other accounting criteria.


They might for example not take management and trading
    costs into account.

They might miss also the evolution of the standards of

living(how does the investment performance fare compared to
the daily bread or daily truffle price?)

On the other hand they might not take into account incomes
    (dividends, rents). Not the same bag, as seen above.

They are victims of some myopic mix of hindsight bias and, in
case of inflation, of money illusion (see those phrases).

This might lead them to

either overtrading (at a cost) and focusing on immediate and apparent

results, neglecting the full accounting picture and the longer view

or undertrading as anchored in the past and not adapt to new
   situations.

Mental laziness
/ Mental myopia

 


See anchoring, recency bias,
saliency, selective attention,

framing, narrow thinking,
tunnel vision, binary logic,
availability heuristic, belief,
certainty, reductionism

Closed eyes and caged neurons, or just sloppiness

Mental laziness and myopiaqualify many bounded cognitive processes,
such as

Seeing, and reasoning on, only the most apparent aspects of things

or according to one's ingrained beliefs / certainties.

Using flawed, apparent or binary logic.

Taking decisions on the basis of generalizations, simplified
    criteria
(heuristics) and reductive dichotomies

(binary logic again).

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

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