Behavioral Finance and Your Portfolio

9Information Processing Bias #1: Mental Accounting Bias

There's no business like show business, but there are several businesses like accounting.

—David Letterman, Television Personality

Bias Description

Bias Name: Mental accounting

Bias Type: Cognitive

Subtype: Information processing

General Description

First coined by University of Chicago professor Richard Thaler, mental accounting describes people's tendency to code, categorize, and evaluate economic outcomes by grouping their assets into any number of nonfungible (noninterchangeable) mental accounts.¹ A completely rational person would never succumb to this sort of psychological process because mental accounting causes subjects to take the irrational step of treating various sums of money differently based on where these sums are mentally categorized, for example, the way that a certain sum has been obtained (work, inheritance, gambling, bonus, etc.) or the nature of the money's intended use (leisure, necessities, etc.). Money is money, regardless of the source or intended use.

The concept of framing is important in mental accounting analysis. In framing, people alter their perspectives on money and investments according to the surrounding circumstances that they face. Thaler² performed an experiment in which he offered one group of people $30 and an accompanying choice: either pocket the money, no strings attached, or gamble on a coin toss, wherein a win would add $9 and a loss would subtract $9 from the initial ...