Behavioral finance VI. Mental accounting
Mental accounting
The first topic highlighted is prospect theory, due to its high popularity among experts. The inspiration for introducing the next theme comes, among other things, from the statement by Belsky and Gilovich: "If Richard Thaler's concept of mental accounting is one of the two main pillars of behavioral economics, prospect theory is the other." Most experts exploring irrational behavior and decision-making in finance draw on the findings of cognitive psychology, which are incorporated into prospect theory and the concept of mental accounting.
Mental accounting is a sequence of cognitive operations performed by individuals, households, or firms to track their financial activities. Three components of mental accounting deserve the most attention:
- The first component addresses how outcomes are received and how decisions are made and then evaluated. This "accounting system" allows for the analysis of inputs in terms of costs or revenues both ex-ante and ex-post.
- The second component of mental accounting involves the assignment of activities to specific accounts. Just as in the mental accounting system, in reality, resources and their uses are similarly allocated and processed. Expenses are categorized, and investment or consumption is tied to planned budgets.
- The third component focuses on the frequency with which accounts are evaluated and the "bracketing of choices," where "bracketing" refers to the issue of framing. Account balancing can occur daily, weekly, or annually and may be specific or general. Each component of mental accounting violates the economic principle of fungibility. Mental accounting influences decision-making, and thus it is significant and must be considered in addressing economic and financial issues.
The theory of mental accounting encompasses two important partial theories that are integral to it. The first is called the "transaction utility theory," and the second is the "gift-giving theory." According to Thaler, their brief definitions are as follows:
Transaction Utility Theory - transaction utility measures the "perceived value of a deal." It is defined as the difference between the amount paid and the reference price of the goods (service or security). The reference price is the expected price that the subject (customer, trader, firm) anticipates paying.
Gift-Giving Theory - this pertains to the second component of mental accounting. The analysis of allocating activities according to budgetary rules highlights that time and prices can change. Ignoring this fact leads to failures when attempting internal arbitrage operations that could, in principle, increase utility. Another insight from this analysis is that people sometimes prefer a gift (in the sense of a tangible gift) over money (a cash gift or financial reward), thereby violating fundamental principles of economic theory. In this case, the gift is on a sort of "prohibited list" and influences the account evaluation processes.
Mental accounting is a theory that includes various phenomena of behavioral finance, such as loss aversion, risk aversion in the domain of gains, risk aversion in general, framing, narrow framing, value derived from prospect theory, gambling, and speculation. When examining individual cases in detail, we could certainly incorporate additional phenomena into this theory. Based on information from the literature, it is evident that mental accounting is rightly defined as the second most significant theory in behavioral finance.
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