Questions: Mental Accounting

Question 1

A person refuses to sell a stock at a loss to buy a better-performing alternative, even though the capital could earn higher returns elsewhere. This behavior most likely reflects...

• A. Rational portfolio management
• B. Mental accounting — closing the stock position at a loss would violate the mental account's expectation of a positive return
• C. Superior knowledge about the stock's future performance
• D. Tax optimization strategy

Answer: (B)

Mental accounting creates a 'mental account' for each investment with an implicit reference point (the purchase price). Selling at a loss would 'close' the account at a loss, making the loss feel real and final. Keeping the stock open preserves the possibility of recovering the loss and closing the account in the positive. This is economically irrational — the optimal portfolio allocation is independent of purchase prices — but psychologically coherent given mental accounting's aversion to closing accounts at a loss.

Question 2

Mental accounting violates the economic principle of fungibility because it treats money differently depending on which mental category it is assigned to.

• T. True
• F. False

Answer: True

Fungibility means that money has no labels — a dollar from wages is identical to a dollar from a gift. Mental accounting violates this by assigning money to categories (food budget, entertainment budget, emergency fund) and applying different spending rules to each. A person might refuse to dip into their 'vacation fund' to cover a medical bill, even though the money is objectively interchangeable. This violation of fungibility can lead to suboptimal resource allocation — money sitting idle in one account while another account is in deficit.

Question 3

What is the 'hedonic editing' hypothesis in mental accounting, and how does it relate to prospect theory?

Model answer: Hedonic editing predicts that people mentally combine or separate outcomes to maximize psychological pleasure (or minimize pain), guided by the shape of the prospect theory value function. The principles are: segregate gains (two separate gains feel better than one combined gain due to diminishing sensitivity), integrate losses (one large loss feels less bad than two separate losses), integrate smaller losses with larger gains (the gain offsets the loss), and segregate small gains from large losses (the 'silver lining' effect). These principles predict how people frame financial outcomes to themselves.

Hedonic editing connects mental accounting to prospect theory's value function. Because the value function is concave for gains (diminishing sensitivity), two $50 gains feel better than one $100 gain — so people should segregate gains. Because it is convex for losses, one $100 loss feels less bad than two $50 losses — so people should integrate losses. Empirical evidence is mixed on whether people actually follow these principles, but the framework explains common mental accounting patterns like savoring individual small gains while lump-summing losses.