Mental accounting: why we sometimes like lower returns

Richard Thaler’s Paper on Mental Accounting Matters, looks at “the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities”, in the Journal of Behavioral Decision Making.

In his work, Richard finds that the framing of gains and losses isn’t often rational.  According to mainstream academic theory, we are all selfish, rational being.  Therefore, we should all be looking to maximize our holdings, presumably?

The evidence suggests otherwise. Firstly “losing $100 hurts more than gaining $100 yields pleasure: v(x)< -v(-x). The influence of loss aversion on mental accounting is enormous”.  

Perhaps we shouldn’t be surprised why, despite the evidence, very few people want to have a portfolio which is 100% in the markets, or even 90% in markets.   Many people prefer a 60% stocks-40% bond portfolio, even though it will usually perform worse over time.  The stability will reassure people, over the better performing, but fluctuating 100% stocks account.

What was also interesting about his research, is that people don’t get used to `losses`. I put losses in inverted commas here, because in investing, a loss doesn’t occur until you sell.

He found that “adding one loss to another should diminish its marginal impact. By wishing to spread out losses, subjects seem to be suggesting that they think that a prior loss makes them more sensitive towards subsequent losses, rather than the other way around. In other words, subjects are telling us that they are unable to simply add one loss to another (inside the value function parentheses). Instead, they feel that losses must be felt one by one, and that bearing one loss makes one more sensitive to the next”.

Perhaps we should not be surprised that few consumers wanted to invest in 2009 when the Dow Jones was at just 7,000+ at one stage, after 9 years of falls.

The “losses” had compounded. If they were just a bit more patient, they would have seen the Dow hit 26,600 this year.  But the human mind isn’t a rational one.  That is just one reason why DIY investors fail.