ECO331 – Mental Accounting & Myopic Loss Aversion

Vocabulary flashcards covering key terms and studies from the lecture on mental accounting, risk aversion, and myopic loss aversion.

Mental Accounting

The cognitive process people use to organize, evaluate and keep track of financial activities by creating mental ‘accounts’ for different categories of money.

Narrow Framing

Evaluating choices within a limited mental account rather than considering overall wealth, often leading to different decisions than broad framing would.

Hedonic Editing

Re-classifying multiple gains and losses to maximize perceived utility; e.g., segregating small gains from big losses or aggregating losses together.

Sunk Cost Bias

The tendency to continue an activity because past, irrecoverable costs are mentally grouped with future benefits in the same account.

Loss Realization Aversion

Reluctance to close a mental account that is currently in loss, leading investors to hold losing assets longer (disposition effect).

Myopic Loss Aversion

Combination of narrow mental accounting and loss aversion that produces strong avoidance of short-term losses despite favorable long-run prospects.

Prospect Theory

Behavioral model where outcomes are valued as gains or losses from a reference point, with loss aversion and diminishing sensitivity.

Reference Point

The status-quo level of wealth or consumption from which gains and losses are evaluated in prospect theory.

Homo Economicus (Broad Framing)

Traditional economic model assuming people maximize utility over final wealth, integrating all outcomes into one account.

Marginal Propensity to Consume (MPC)

Fraction of an additional dollar of income that is spent on consumption; varies by mental account (current, asset, future).

Permanent-Income Hypothesis Accounts

Current income account (high MPC), asset account (medium MPC), and future income account (near-zero MPC).

Relativity in Mental Accounting

Comparing costs to other expenditures of similar size and frequency, as in 'pennies-a-day' framing.

Pennies-a-Day Framing

Presenting a lump sum as a small daily amount to fit it into a small-expense mental account and increase compliance or donations.

Motivated Bracketing

Choosing mental account boundaries strategically (often subconsciously) to justify preferred actions.

Disposition Effect (Odean, 1998)

Investors are more likely to sell winning stocks than losing ones, explained by mental accounting and loss realization aversion.

Kooreman (2000) Study

Found Dutch child-benefit income had high MPC for children’s clothing but negative MPC for adult clothing, illustrating category-based accounts.

Hastings & Shapiro (2018)

Showed SNAP’s restricted grocery benefits change spending more than equivalent cash, contradicting homo economicus predictions.

Rebate Checks vs. Withholding

Tax rebates (lump sums) are mostly saved, while reduced withholding (ongoing gains) are largely spent—evidence of separate mental accounts.

Restricted vs. Unrestricted Benefits

Benefits limited to specific goods (e.g., food stamps) are not fully fungible with cash because of mental accounting categories.

Arrow’s Small-Stakes Puzzle

Expected-utility theory implies near risk-neutrality for small gambles, yet people display risk aversion, suggesting narrow framing.

Rabin (2000) Calibration Theorem

Demonstrates that rejecting small, favorable gambles under expected-utility implies implausibly extreme risk aversion over larger stakes.

Samuelson’s Bet

A 50-50 lose-$100/gain-$200 gamble often rejected individually but accepted when aggregated, illustrating myopic loss aversion.

Hedonic Editing Rules

Break up gains, aggregate losses, offset small losses with larger gains, and segregate large losses from small gains to maximize utility.

Current vs. Windfall Income

Windfalls (bonuses, refunds) are more likely to be ‘splurged’ or saved differently than regular salary because they enter separate accounts.

Motivated Sunk Cost Example

Attending a snow-storm concert because the paid ticket cost is mentally linked to the event, whereas a free ticket reduces commitment.

Category Budgeting

Assigning spending limits to narrow categories (e.g., clothing, entertainment), which can prevent fungibility of money.

Myopic Evaluation Horizon

Frequent evaluation of portfolio performance that, combined with loss aversion, leads to excess equity avoidance.

Creative Accounting

Another term for hedonic editing—relabeling or grouping outcomes to influence perceived utility.

Mental Closing of Accounts

Registering utility once an account is ‘settled’; reluctance to close at a loss fuels sunk-cost behavior.

Asset Account

Mental account for wealth changes tied to investment or savings, typically with medium MPC.