Behavioral Finance, Osa 4

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Tämä on viimeinen osa käyttäytymisperusteisen rahoituksen eli behavioral financen kirjoitussarjasta. Sarjan ensimmäinen, toinen ja kolmas osa on luettavissa oheisista linkeistä. Tekstin on kirjoittanut Oulun yliopiston rahoituksen professori Hannu Kahra ja se perustuu pitkälle John Nofsingerin kirjaan Psychology of Investing.

2.9 Mental accounting

Businesses, governments, and even churches use accounting systems to track, separate, and categorize the flow of money. People, on the other hand, use a mental accounting system. Imagine that your brain uses a mental accounting system similar to a file cabinet. Each decision, action, and outcome is placed in a separate file folder in the file cabinet. The folder contains the costs and benefits associated with a particular decision. Once an outcome is assigned to a mental folder, it is difficult to view that outcome in any other way. The ramifications of mental accounting are that it influences your decisions in unexpected ways.

 

Consider the following example.

 Mr. and Mrs. J have saved $15,000 toward their dream vacation home. They hope to buy the home in five years. The money earns 4 percent in a money market account. They just bought a new car for $11,000 that they financed with a three-year car loan at 9 percent.

This is a common situation. People have money in savings that earns a low rate of return yet borrow money at a high interest rate, thus losing money. In this example, the vacation home savings in the money market account is earning a rate of 4 percent. Imagine how excited Mr. and Mrs. J would be if they found a safe investment earning 9 percent! But when the 9 percent opportunity came up, they probably didn't even consider it. That opportunity was to borrow the $11,000 from their own savings (instead of the bank) and pay themselves a 9 percent interest rate. If they had done this, the vacation home savings in the money market account would have been more than $1,000 higher at the end of the three years.

Money does not come with labels, so people put labels on it. We've designated dirty money, easy money, free money, and so on. Mr. and Mrs. J labeled their savings as "vacation home" in a mental account. Although mixing the "new car" mental account with the "vacation home" account would have maximized their wealth, Mr. and Mrs. J could not bring themselves to do it.


2.9.1 Mental budgeting

People use financial budgets to keep track of and control their spending. The brain uses mental budgets to associate the benefits of consumption with the costs in each mental account. Consider the pain (or costs) associated with the purchase of goods and services to be similar to that of the pain of financial losses. Similarly, the joy (or benefits) of consuming the goods and services is like the joy of financial gains. Mental budgeting matches the emotional pain to the emotional joy.


2.9.2 Matching costs to benefits

People usually prefer a "pay-as-you-go" payment system because it provides a tight match between the benefits and costs of the purchase. However, things get more complicated when the pay-as-you-go system is not available.

Consider the following set of questions that investigate the timing of payments. Professors Drazen Prelec and George Loewenstein asked 91 visitors to the Phipps Conservatory in Pittsburgh the following questions. The first question is this.

Imagine that six months from now, you are planning to purchase a clothes washer and dryer for your new residence. The two machines together will cost $1,200. You have two options for financing the washer/dryer:
A. Six monthly payments of $200 each during the six months before the washer and dryer arrive.
B. Six monthly payments of $200 each during the six months be- ginning after the washer and dryer arrive.

Which option would you choose? Note that the total cost is the same in both options; only the timing of the costs is different. Of the 91 people interviewed, 84 percent responded that they preferred the postponed payment schedule B. This is consistent with the cost/benefit matching of mental budgeting. The benefits of the washer and dryer will be used for a period of years after their purchase.

Paying the cost over a concurrent period matches the cost to the benefit. Note that option B is also consistent with traditional economic theories; that is, people should choose B because it is less expensive after considering the time value of money.

The next two examples are not consistent with traditional economic theories, and respondents did not select the wealth-maximizing option. Consider this example.

Imagine that you are planning to take a one-week vacation to the Caribbean six months from now. The vacation will cost $1,200. You have two options for financing the vacation:
A. Six monthly payments of $200 each during the six months before the vacation.
B. Six monthly payments of $200 each during the six months be- ginning after you return.

Notice that the payment stream options are the same as in the prior question - six payments before or six payments after the purchase. The difference is that the item being purchased has changed. The main difference is that the vacation is a purchase whose benefits will be consumed in a short time, whereas the benefits of the washer and dryer will be consumed over the course of years. Which option would you choose?

Sixty percent of the respondents selected option A, the prepaid vacation. In this case, the payment options do not match with the consumption of the goods. The benefits of vacations are consumed during the vacation, but this vacation must be paid for either before or afterward.

Traditional economic theories predict that people will prefer option B because it is cheaper after considering the time value of money. However, most people choose option A. Why? People believe that a prepaid vacation is more pleasurable than one that must be paid for later because the pain of payment is over. If payment is to be made later, the benefits of the vacation are diminished by wondering how much the pleasure is going to cost. An important factor in the "prepay or finance it" decision is the amount of pleasure expected to be generated by the purchase. The thought of paying for an item over the time that the item is being used reduces the pleasure of using that item. But let's face it: Using a washer and dryer is not that much fun anyway, so we might as well finance it. The dream home example at the beginning of this chapter is another matter. The pleasure of the dream home should not be tainted with debt and the thoughts of future payments; therefore, Mr. and Mrs. J are prepaying (saving for) the house.

The third question to the visitors addressed income from overtime work to be performed: How would you like to get paid for working a few hours on the weekends during the next six months? Prepayment for work to be done in the future was not desirable. Sixty-six of the respondents preferred to get paid after doing the work instead of before. Again, this is not consistent with traditional economic theories. The wealth-maximizing option is to get paid earlier, not later.


2.9.3 Aversion to debt

In the vacation and overtime questions, people are expressing an aversion to debt when the good or service is consumed quickly. People show a preference for matching the length of the payments to the length of time the good or service is used. For example, using debt to purchase homes, cars, TVs, and so forth is popular because these items are consumed over many years. Using debt and paying off the purchase over time results in a strong match associated with the consumption of those items.

On the other hand, people do not like to make payments on a debt for a purchase that has already been consumed. Financing the vacation is undesirable because it causes a long-term cost on a short-term benefit. This is also true for the third question. People do not want to get prepaid for work because it creates a long-term debt (working weekends for the next six months) for a short-term benefit (getting paid). People prefer to do the work first and then get paid.


2.9.4 Sunk-cost effect

Traditional economic theories predict that people will consider the present and future costs and benefits when determining a course of action. Past costs should not be a factor. Contrary to these predictions, people routinely consider historic, nonrecoverable costs when making decisions about the future. This behavior is called the sunk-cost effect. The sunk-cost effect is an escalation of commitment and has been defined as the "greater tendency to continue an endeavor once an investment in money, time, or effect has been made."

Sunk costs have two important dimensions: size and timing. Consider the following two scenarios.

A family has tickets to a basketball game, which they have been anticipating for some time. The tickets are worth $40. On the day of the game, a big snowstorm hits their area. Although they can still go to the game, the snowstorm will cause a hassle that will reduce the pleasure of watching the game. Is the family more likely to go to the game if they purchased the tickets for $40 or if the tickets were given to them for free?

The common belief is that the family is more likely to go to the game if they purchased the tickets. Note that the $40 cost of the ticket does not factor into the hassle of the snowstorm or the pleasure derived from the game. Yet people consider the sunk cost in their decision whether to go. A family that pays for the tickets opens a mental account. If they do not attend the game, the family is forced to close the mental account without the benefit of the purchase, resulting in a perceived loss. The family wishes to avoid the emotional pain of the loss; therefore, they are more likely to go to the game. Had the tickets been free, the account could be closed without a benefit or a cost.

This example illustrates that the size of the sunk cost is an important factor in decision making. In both cases the family had tickets, but it was the cost of the tickets ($40 versus $0) that mattered. The next example illustrates that the timing of the sunk cost is also an important component.

A family has long anticipated going to the basketball game, which will take place next week. On the day of the game, a snowstorm occurs. Is the family more likely to go to the game if they purchased the $40 tickets one year ago or yesterday?

In both cases, the $40 purchase price is a sunk cost. However, does the timing of the sunk cost matter? Yes, the family is more likely to go to the game if they purchased the tickets yesterday than if they purchased the tickets last year. The pain of closing a mental account without a benefit decreases with time. In short, the negative impact of a sunk cost depreciates over time.


2.9.5 Economic impact

The previous examples demonstrate that people are willing to incur monetary costs to facilitate their mental budgeting process. Remember that people tend to prepay for some purchases, and they prefer to get paid after doing the work. By accelerating payments and delaying income, they are not taking advantage of the time value of money principles. Traditional economic theories predict that people would prefer the opposite: delaying payment and accelerating income to maximize the present value of their wealth.

Mental accounting causes people to want to match the emotional costs and benefits of a purchase. Their determination frequently leads to expensive decisions. Consider the following example.

Fifty-six MBA students were asked to select a loan to finance the $7,000 cost of a home-remodeling project. The project involved redecorating (new carpet, wallpaper, paint, and so on) and would last four years, at which point they would have to redecorate again. Two borrowing options were given. One loan had a three-year term and an interest rate of 12 percent. The other was a 15-year loan with an 11 percent interest rate. Both loans could be prepaid without penalty.

Note that the long-term loan has a lower interest rate. In addition, the 15-year loan can be converted into a three-year loan (that has a lower interest rate) by merely accelerating the payments. That is, you could calculate the monthly payment needed to pay off the 15-year loan in only three years. Because the interest rate on the 15-year loan is lower than on the three-year loan, the monthly payments would be lower. When asked, 74 percent of the MBA students preferred the three-year loan. These students indicated a willingness to incur monetary costs (in the form of a higher interest rate) to make it easier to integrate related costs and benefits. The students were willing to pay a higher interest rate in order to guarantee - that the loan will be paid in only three years. This is an example of the self-control problem.


2.9.6 Mental accounting and investing

Decision makers tend to place each investment into a separate mental account. Each investment is treated separately, and interactions are over-looked. This mental process can adversely affect an investor's wealth in several ways. First, mental accounting exacerbates the disposition effect. Recall that investors avoid selling stocks with losses because they do not want to experience the emotional pain of regret. Selling the losing stock closes the mental account, triggering regret.

Consider the wealth-maximizing strategy of conducting a tax swap. A tax swap is when an investor sells a stock with losses and purchases a similar stock. For example, suppose you own Northwest Airlines stock, which has experienced a price decline along with the entire airline industry. You could sell the Northwest stock and purchase United Airlines stock. This tax swap allows you to capture the capital loss of Northwest stock to reduce your taxes while staying invested and waiting for the airline industry rebound.

Why isn't the tax swap strategy used more often? Investors tend to consider the selling of the loser stock as a closing of that mental account and the buying of the similar stock as an opening of a new mental account. This causes two outcomes that affect investors. First, the interaction between these two accounts increases the investor's wealth. Second, the closing of the loser account causes regret. Investors tend to ignore the interaction between accounts; therefore, investors act to avoid regret instead of to maximize wealth.

Mental budgeting compounds the aversion to selling losers. Consider how people value the timing of payments and benefits. As time passes, the purchase of the stock becomes a sunk cost. The emotional pain of wasting some of the sunk cost on a loser diminishes over time. It may be less emotionally distressing for the investor to sell the losing stock later as opposed to earlier.

When investors do decide to sell a loser, they have a tendency to bundle more than one sale on the same day. Investors integrate the sale of losers to aggregate the losses and limit the feeling of regret to one time period. In other words, people may combine the separate mental accounts in losing positions and close them out all at once in order to minimize their regret. Alternatively, investors like to separate the sale of winners over several days to prolong the more favorable feeling. Sonya Lim studied the selling behavior of 50,000 brokerage accounts (425,000 sell trades) from 1991 to 1996. She found that investors are likely to sell more than one losing stock on the same day. On the other hand, if a winner stock is sold, selling another winner stock on the same day is less likely. She concludes, "Investors can maximize their happiness by savoring gains one by one, while minimizing the pain by thinking about the overall loss rather than individual losses." Can the sale with loss be integrated with the sale with a gain at the same time to mitigate the regret? It depends on the relative magnitudes of the loss and gain. Remember that prospect theory says the pain of a loss is greater than the happiness of a gain of the same magnitude. So, if the magnitude of the loss is larger than the magnitude of the gain, the investors will segregate them by selling on different days. If the magnitude of the loss is smaller than the gain, then the investor may integrate them by selling on the same day.

The narrow framing aspect of mental accounting might also explain why so many people do not invest in the stock market, even though stocks have a high mean return. The stock market risk has nearly zero correlation with a person's other economic risk, namely, labor income risk and housing price risk. Therefore, adding even a small amount of stock market risk provides diversification of one's overall economic risk. However, in isolation, which is how people tend to view things, the stock market appears much riskier than labor income risk and housing price risk.

As an example, consider the distribution of asset allocation within U.S. 401(k) retirement plans. A study of nearly 7,000 accounts from one large firm found the allocations to be strongly bimodal. About 48 percent of the participants do not allocate any money to equities. Another 22 percent allocate all of their money to equities. In all, 70 percent of the accounts were completely undiversified among asset classes. These allocations seem more consistent with mental accounting than with decision making from a portfolio perspective.

Mental accounting also affects investors' perceptions of portfolio risks. The tendency to overlook the interaction between investments causes investors to misperceive the risk of adding a security to an existing portfolio. Mental accounting leads to the building of portfolios layer by layer. Each layer represents the investment choices that satisfy various mental accounts. This process allows investors to meet the goals of each mental account separately. It does not lead to the benefits of diversification shown by portfolio theory. In fact, people usually don't think in terms of portfolio risk. Consider the financial adviser advising a client that they should take a little more investment risk to acquire more money for retirement. If asked, "Would you prefer to take a lot more risk with some of your money, or would you prefer to take a little more risk with all of your money?" people tend to think in terms of the first choice, which is consistent with mental accounting. The second choice is from the perspective of modern portfolio theory.


Behavioral financea käsittelevä kirjoitussarja päättyy tähän. Toivon sarjan antaneen lukijoille paremman kuvan siitä mitä behavioral finance on ja miten se vaikuttaa sijoittajien käyttäytymiseen. Sijiottajat eivät läheskään aina toimi kuten akateemiset teoriat antaisivat olettaa. Behavioral finance antaa hyvät selitykset miksi näin tapahtuu. Kun tiedostaa omat heikkoudet on niitä vastaan suojautuminen helpompaa.