Mental Accounting Matters - Essay Example

Critical evaluation of Mental Accounting Theory in relation to prospects of gains and losses Keeping the track of how finances are spent, while also seeking for ways to control the spending is a fundamental concept of accounting, whether for businesses, organizations, households or individuals. Households and individuals apply a set of cognitive processes in organizing, assessing and the keeping track of their financial behaviors. This cognitive processes, also referred to as mental accounting, form the basis on which the individuals and households make financial decisions and evaluate them, based on how the outcomes of such financial decisions are perceived and experienced. Thus, this discussion seeks to analyze the cognitive process of organizing, using and keeping track of financial usage for individuals and households, as related to the forecasting for possible attainment of gains or losses. In realizing this evaluation, the discussion will first assess the process of assigning and grouping different financial expenditures into different categories referred to as mental accounts, followed by the evaluation of the factors informing the choice financial spending or investment functions to align with the predicted chances of gains or losses. The Mental Accounting Theory provides an explanation related to how households and individuals keep track of where their incomes are going and how such entities apply active cognitive processes to control their financial spending (Dawes, 2001:47). The difference between conventional financial accounting undertaken by business entities and the mental accounting applied by individuals and households is that; there lacks specific and elaborate rules on how mental accounting procedures should be undertaken. Thus, the process of mental accounting can only be achieved through observing financial behaviors, and then inferring rules to the behaviors, so as to control future spending. Thus, due to the lack of elaborate rules to guide financial allocations to various individual or household spending activities, these entities apply a variety of subjective criteria that sees finances prioritized and allocated to different spending functions, for example based on the sources of the incomes or the intent for the specific functions (Baddeley, 2013:147). Thus, the Mental Accounting Theory provides that individuals and households irrationally assign different spending functions to a certain asset group, which in turn results in detrimental effects on the spending behavior and consumption decisions subsequently mad by the entities (Tversky & Kahneman, 1981:455). In this respect, the application of the mental accounting process seeks to target future gains, while averting possible loses, through balancing all potential spending and consumption functions of the individuals and households, in a manner that ensures that no consumption or spending function lags behind. Nevertheless, while the intention of mental accounting is noble, the overall effect is that it delivers more losses to the individuals than the perceived gains that the individuals obtain from the cognitive financial planning and organization. Take for example an individual setting aside a saving jar where the individual keeps all the loose change obtained from conventional monthly or weekly shopping activities, for the purpose of accumulating enough money for going to a holiday vacation, while purchasing other household items using a credit card. The ultimate goal of the individual may be realized, since the saving jar might eventually accumulate enough money for going to a holiday vacation, without requiring the individual to do any further out of pocket contribution for the same. The major problem however, is the fact that; while the individual could accumulate enough money for a holiday vacation through saving loose change in a saving jar, his/her credit burden continues to increase, considering that the rest of the household items are purchased using a credit card debt that earns an annual interest of a certain percentage. The overall effect is that by the end of the year, the individual will have indirectly borrowed to go for a holiday through the credit card transactions, and thus accumulated high financial losses through interests, as opposed to when the individual would have used the savings from the savings jar to pay the credit card debts, and then borrow money for holiday vacations from less expensive sources (Kahneman & Tversky, 2000:77). The major question that arises from this scenario is, why then do individuals engage in financial organization and spending behaviors that ultimately see them increasing their losses, as opposed to planning their incomes in a rational manner that would reduce the losses incurred and thus maximize on the financial gains of the individuals? Richard Thaler, through the Mental Accounting Theory hypothesis, responds to this question through positing that psychological satisfaction arising from the irrational mental accounting and spending behavior is far much important to the individuals than the overall gain-to-loss balancing (Thaler, 2008:15). Therefore, personal value is the fundamental principle as far as mental consumption theory is involved, due to the fact that; as opposed to financial prudence, the mental and psychological satisfaction derived from the irrational organization of funds through the cognitive operations of individuals is worth too much for the individuals, as opposed to their actual comfort in rational financial spending that would maximize their gains (Thaler, 2008:22). For example, when evaluating the credit card losses through credit card interests and the financial comfort derived from, for example, savings for children’s college school fees or saving for a home ownership plan, the college fee plan and homeownership savings are too important for an individual or household to relinquish, for the sake of clearing their credit card debts and thus preventing further financial losses through interests. Thus, these important accounts may not be touched or interfered with at all, even though doing away with them will be a more financially beneficial decision for the individual or household (Plous, 1993:56). Thus, the principle of mental accounting always creates an accounts dilemma, whenever the available resources are not sufficient to cover for all the designated accounts that are set for different purposes. Despite the fact that such accounts dilemma can be avoided through the application of rational decision making as opposed to psychological decision making for financial planning and organization, the concept of personal value attached to different designated accounts takes preference, resulting in the higher urge to prioritize personal value over added financial benefit arising from the reorganization of the accounts (Thaler, 1999:187). The Mental Accounting Theory sharply contrasts with the Utility Theory, owing to the fact that the utility theory considers the outcome of the total wealth of an individual or a household, while the Mental Accounting Theory simply focuses on the utility of different items as set in different accounts, which cannot be integrated and measured in full utility measures (Tversky & Kahneman, 1981:457). Thus, the Mental Accounting Theory is based on the prospects of gain and losses for each specific account of separate items that the individual or the household has set, while the utility theory focus on the utility derived from the final wealth. Thus, the utility theory holds that it is prudent to combine the entire individual or household finances into a pooled resource account, from where the individuals can be able to allocate their resources in a manner that will minimize financial loses. The two theoretical perspectives differentiates the treatment of financial resources by individuals, where under the utility theory, individuals will utilize financial resources rationally, based on the utility they derive by drawing financial resources from the pooled resource fund, which in turn tends to reduce the risk of spending on high risk ventures (Grinblatta & Hanb, 2005:312). On the other hand, the utility under the mental accounting theory is purely based on each separate item of financial spending, such that there is a greater risk of spending resources in a high risk area, if the area derives higher levels of psychological satisfaction for an individual, compared to another low risk spending area. For example, under the mental accounting concept, there is a tendency to reduce the risks of spending associated with direct cash spending, as opposed to the risk of spending under credit spending (Hastie & Dawes, 2001:21). In this respect, an individual may place a high bet while using a credit card to bet, as opposed to when the same individual is using cash to bet, despite the fact that both cash and credit card spending will eventually impact on the financial position of the individual by reducing his/her total worth. The mental accounting concept measures utility in terms of ‘giving something up’ (loss), against ‘receiving something’ (gain) as opposed to the overall outcome of financial decision, that either decreases or increase the total financial wealth of an individual. The prospects of gains and losses are affected by the concept of mental accounting through the same process of irrational decision making in investment. This is because; the same way individuals or households apply separate utility from separate items of accounts that are set for the purpose of controlled spending, the investors also make their investment decisions based on the potential gains or losses that might amount from different portfolios of investment, as opposed to the overall financial consequence of the investment portfolios (Kahneman & Tversky, 2000:102). Thus, the investors applying the mental accounting theory will divide their investments between the potential safe investments that are not likely to generate any losses or gains, thus resulting in a prospective gain or loss of zero, and the speculative investment portfolios with the potential of either generating gains or losses, as opposed to investing under one large portfolio (Shaw, 2006:115). The impact of such piecemeal investments is that; the investors will lose more money in the process of dividing the investment into separate portfolios, which is equal to the prospective loss that could amount from the losses deliverable from a speculative portfolio, while entirely foregoing any prospective positive gain that could amount through investment in a large speculative portfolio (Thaler, 2008:24). The overall effect of such investment decisions is that the investors highly reduces any chances of making financial gains from speculative investments, owing to the fact that the investors do not measure the prospective gains in financial terms, but otherwise in terms of the possible psychophysical function of potential happiness or sadness resulting from the investment outcome (Thaler, 1999:205). Thus, the Mental Accounting principle is therefore inhibitive to investment, since it treats money as a non-fungible commodity, through separating the same pool of financial resources into different components that are not potentially viable. Thus, to overcome this inhibition, money should be treated as a fungible commodity, where money from whichever source and for whatever purpose can be transferrable into a different function, on the event that the alternative function appears to be more viable financially. Thus, as opposed to maintaining high debts for the sake of having the available resources being spread in different financial spending functions, it is prudent to forego either saving for certain functions or even splitting the investment portfolios, so that the available debt can be covered, and avert the possible losses arising from the interests payable on such debts. References Baddeley, M. (2013). Behavioral Economics and Finance. Routeledge. Dawes, M. (2001). Everyday Irrationality: How Pseudo-Scientists, Lunatics, and the Rest of Us Systematically Fail to Think Rationally. Boulder, CO: West view Press. Grinblatta, M. & Hanb, B. (2005). Prospect theory, mental accounting, and momentum. Journal of Financial Economics 78(2), 311–339. Hastie, R. & Dawes, M. (2001). Rational Choice in an Uncertain World: The Psychology of Judgment and Decision Making. Thousand Oaks: Sage Publications. Kahneman, D. & Tversky, A. (2000). Choices, Values, and Frames. Cambridge: Cambridge University Press. Plous, S. (1993). The Psychology of Judgment and Decision Making. New York: McGraw-Hill. Shaw, M. J. (2006). E-Commerce and the Digital Economy. Armonk: M.E. Sharpe, Inc. 115 Thaler, R. H. (2008). Mental Accounting and Consumer Choice. Marketing Science 27(1), 15–25. Thaler, R. H. (1999). Mental Accounting Matters. Journal of Behavioral Decision Making 12, 183-206. Tversky, A. & Kahneman, D. (1981). The framing of decisions and the rationality of choice. Science 211, 453–458. Read More