Cognitive biases like mental accounting may sabotage your financial decisions as an investor or manager of money, leading to suboptimal investments like the sunk cost fallacy and anchoring.
These biases can be amplified in situations like tax refunds and inheritances. This paper builds upon previous work to identify individual differences which mitigate mental accounting effects.
Long-Term vs. Short-Term
Mental accounting is a behavioral concept which describes people’s tendency to evaluate outcomes differently depending on where the money came from. Richard Thaler pioneered it by proposing that individuals tend to evaluate gains separately in order to maximize pleasure while group losses together in order to minimize pain – something known as “hedonic editing”.
In our experimental studies, we employ a five-item scale to assess mental accounting. Its scores moderate the effects of theater ticket and cash loss experiments (Tversky and Kahneman, 1981), as well as conducting an explorative survey using these same measures to explore correlations; such as socio-demographic characteristics such as age, sex, education level and income as well as psychological constructs like personality traits such as extraversion, agreeableness, neuroticism and conscientiousness and hedonic editing.
Mental accounting has been found to be related to female gender, lower education levels and strong financial literacy. Furthermore, its association with Big Five personality traits remains uncertain while any possible role for nonplanning impulsivity remains ambiguous.
Behavioral Finance
Behavioral finance challenges the efficient market theory by acknowledging human emotions and cognitive biases contribute to investor mistakes and mispricings. Furthermore, it acknowledges humans have limited cognitive capacities that cannot process huge volumes of data rationally; consequently investors often make investment decisions using simplified heuristics or rules-of-thumb to guide their investment decisions.
Cognitive biases such as herding behavior, overconfidence bias and confirmation bias can cause you to act contrary to your financial goals and risk tolerance. Furthermore, heuristics may lead to excessive trading and increased transaction costs that reduce returns over time.
Understanding common behavioral finance pitfalls can help you avoid them and invest wisely. To minimize their influence on your decision-making, develop a comprehensive plan with your advisor that details your financial goals and risk tolerance as well as an array of investment strategies; doing this may reduce impulsive investing behaviors like buying or selling stocks in response to emotional news reports.
Loss Aversion
Mental accounting refers to the practice of treating various forms of money differently depending on where they come from and their intended use, leading to biases like loss aversion and the sunk cost fallacy. Investors must be mindful of mental accounting’s potential influence on decision-making processes and find ways to overcome any potentially detrimental biases that might hinder effective investing decisions.
Prioritize your financial goals. This will allow you to prioritize saving for those goals instead of spending on unnecessary things. Or use a budgeting app like Mint to track expenses and ensure you’re staying within your means.
Survey research into individual differences in engaging in mental accounting has been limited and exploratory, until now. In the present study, using a simple Likert-type scale, individuals’ engagement in mental accounting was measured and explored for correlates within this construct. A convenience sample was used and results are both descriptive and exploratory in nature.
Anchoring
Most empirical research on mental accounting focuses on its general effects on behavior and pays little heed to interindividual variations. Our experimental studies reveal that individual differences in keeping separate mental accounts for gains and losses has an immense influence on spending decisions when prior experiences are involved in decision scenarios. Furthermore, we employ a questionnaire survey as well as statistical tools for investigating correlates of mental accounting measures.
Our exploratory study revealed that engaging in mental accounting was associated with being female, having lower education but excellent financial literacy, and being conscientious. Other socio-demographic and personality variables have also been shown to correlate with mental accounting engagement, so further research should include using representative samples of participants for further investigations on this topic. Such research might involve contrasting existing measures of money management as well as psychological constructs like extraversion, agreeableness, neuroticism, and emotional stability with mental accounting measures to gain more insight into its interaction between various components.
