💳Behavioral Finance Unit 7 – Mental Accounting and Framing Effects

Key Concepts

• Mental accounting involves separating financial decisions into distinct mental accounts rather than considering the overall impact on wealth
• Framing effects occur when different presentations of the same information lead to different choices or preferences
• Prospect theory proposes that people make decisions based on the potential value of losses and gains rather than the final outcome
  • Includes the concept of loss aversion, where the pain of losing is psychologically about twice as powerful as the pleasure of gaining
• Narrow framing focuses on the individual components of a choice rather than the big picture, leading to suboptimal decisions
• Hedonic editing describes how people mentally combine or separate outcomes to make them more pleasurable or less painful
• The endowment effect causes people to value an object more highly when they own it compared to when they don't
• The sunk cost fallacy involves continuing a behavior or endeavor as a result of previously invested resources (time, money, or effort)

Cognitive Biases

• Confirmation bias leads people to search for, interpret, favor, and recall information in a way that confirms or supports their prior beliefs or values
• Anchoring bias occurs when an individual relies too heavily on an initial piece of information offered (the "anchor") when making decisions
• Availability heuristic is a mental shortcut that relies on immediate examples that come to a person's mind when evaluating a specific topic, concept, method, or decision
  • Can lead to overestimating the likelihood of events that are more easily remembered, such as recent or emotionally charged events
• Representativeness heuristic involves making judgments based on how similar an outcome is to a prototype that already exists in our minds
• Overconfidence bias is the tendency for a person's subjective confidence in their judgments to be reliably greater than their objective accuracy
• Hindsight bias is the common tendency for people to perceive past events as having been more predictable than they actually were
• Status quo bias is an emotional bias that causes people to resist change and prefer the current state of affairs

Decision-Making Process

• Framing the decision involves defining the problem, identifying the objectives, and gathering relevant information
  • The way a problem is framed can significantly influence the decision-making process and the final choice
• Generating alternatives consists of identifying potential courses of action or solutions to the problem at hand
• Evaluating alternatives involves assessing the costs, benefits, and risks associated with each option
  • Mental accounting can lead to evaluating alternatives in isolation rather than considering the overall impact
• Making the choice is the step where the decision-maker selects the alternative that best meets their objectives and preferences
  • Framing effects can cause the decision-maker to choose differently depending on how the options are presented
• Implementing the decision involves taking action to carry out the chosen course of action
• Monitoring and evaluating the outcome is essential to determine whether the decision was effective and to learn from the experience

Real-World Applications

• Retirement savings: Mental accounting can lead individuals to treat their retirement accounts as separate from their other investments, potentially resulting in suboptimal asset allocation
• Insurance purchases: Framing effects can influence whether people choose to buy insurance, depending on whether the policy is presented as a potential gain (protection) or a loss (cost)
• Consumer behavior: The endowment effect can cause people to value items they own more highly, leading to higher asking prices when selling goods (eBay auctions)
• Health decisions: Framing a treatment option in terms of survival rates vs. mortality rates can influence a patient's decision to undergo the treatment
• Investing: The sunk cost fallacy can cause investors to hold onto losing investments for too long, hoping to recoup their initial investment
• Marketing: Advertisers can use framing effects to influence consumer preferences by highlighting specific product attributes or benefits (emphasizing "80% lean" vs. "20% fat")

Experimental Evidence

• Kahneman and Tversky's (1979) experiment demonstrated the framing effect by presenting participants with a hypothetical disease outbreak scenario
  • Participants chose differently between programs framed in terms of lives saved vs. lives lost, despite the outcomes being mathematically equivalent
• Thaler's (1985) study showed mental accounting in action by observing how people treated windfall gains differently from regular income
  • Participants were more likely to spend unexpected windfalls on luxuries rather than necessities
• Samuelson and Zeckhauser's (1988) experiment revealed the status quo bias by asking participants to choose between hypothetical investment options
  • Participants disproportionately chose to stick with their current investment plan, even when better options were available
• Arkes and Blumer's (1985) study demonstrated the sunk cost fallacy using a scenario involving a hypothetical airplane company
  • Participants were more likely to invest additional funds in a failing project if they had already invested a significant amount of money

Implications for Investors

• Be aware of mental accounting and consider the overall impact of financial decisions on net worth rather than treating accounts separately
• Recognize the influence of framing effects and try to evaluate investment options objectively, focusing on the underlying fundamentals
• Avoid the sunk cost fallacy by regularly reassessing the merits of an investment, regardless of the amount already invested
• Be mindful of the endowment effect when buying or selling investments, and try to assess their value impartially
• Seek out contrary opinions and evidence to mitigate confirmation bias when researching investments
• Use decision-making frameworks and checklists to ensure a thorough and unbiased evaluation of investment opportunities

Critiques and Limitations

• Some researchers argue that mental accounting can be a useful tool for self-control and budgeting, helping people to allocate funds for specific purposes
• The generalizability of framing effects has been questioned, as the strength of the effect may vary depending on the context and the individual's expertise
• Critics argue that the endowment effect may not be as strong or universal as initially thought, and that it can be mitigated by factors such as market experience
• The sunk cost fallacy may be less prevalent in real-world settings where decision-makers have access to more information and feedback
• Some studies have found that the impact of cognitive biases can be reduced through education, experience, and the use of decision aids

Future Research Directions

• Investigating the neural basis of mental accounting and framing effects using functional magnetic resonance imaging (fMRI) and other neuroimaging techniques
• Examining the role of emotions in decision-making and how they interact with cognitive biases
• Exploring the effectiveness of debiasing techniques, such as considering opportunity costs or using decision-making frameworks, in reducing the impact of mental accounting and framing effects
• Studying the influence of cultural factors on the prevalence and strength of cognitive biases in financial decision-making
• Investigating the potential benefits of mental accounting and framing effects in promoting positive behaviors, such as saving for retirement or adopting healthy habits
• Developing and testing interventions to help investors overcome cognitive biases and make more rational decisions
• Examining the long-term effects of mental accounting and framing on financial outcomes, such as wealth accumulation and portfolio performance