Behavioural Finance
Mental Framing
Session 4
Read
Thaler, 2000
Thaler, 1999
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Who is better off?
 Anna and Barbara graduated from Cass a year apart.
Upon graduation both took similar jobs with publishing
firms. Ann started with a yearly salary of £30,000.
During her first year on the job there was no inflation
and in her second year Ann received a 2 percent (£600)
raise in salary. Barbara also started with a salary of
£30,000 per year. During her first year on the job, there
was 4 percent inflation and in her second year Barbara
received a 5% (£1,500) raise in salary.
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Who is better off?
As they enter their second year on the job, who
was doing better in economic terms? Ann or
Barbara?
As they entered their second year on the job,
who do you think was happier? Ann or Barbara?
As they entered their second year on the job,
each received a job offer from another firm.
Who do you think is more likely to leave her
present position for another job? Ann or
Barbara?
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How does Markowitz construct his
portfolio?
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Framing
Difference between form and substance
Framing is about form
it reflects a mix of cognitive and emotional
elements!
Regret is an emotion
people who have difficulty controlling emotions
are said to lack self control
people use framing effects to constructively help
themselves deal with self control difficulties!
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What would you do?
Imagine that you are about to purchase a
t-shirt from Marks and Spencers at the
corner for £15. The salesman informs you
that the t-shirt is on sale for £10 at the
Oxford Street branch. Would you make
the trip to Oxford Street?
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What would you do?
Imagine that you are about to purchase a
black trouser suit from Marks and
Spencers at the corner for £150. The
salesman informs you that the t-shirt is on
sale for £145 at the Oxford Street branch.
Would you make the trip to Oxford Street?
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Hedonic Framing
The way the decision is made will not
alter choices if the decision maker is using
a wealth based analysis!
You save £5 in either case!
Framing does alter choice because people
make decisions piecemeal!
£5 is a significant saving on a £15 purchase
but not so on a £150 purchase!
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Have you ever?
Bought something because it was on
sale?
Made two budgets?
One for entertainment?
One for food?
Invested windfall gains into something
luxurious?
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Mental Accounting
A mental account
is a frame for evaluation!
Accounting
a system of recording an summarizing
financial transactions in books and analyzing,
verifying and reporting results
Money in one mental account
is not a perfect substitute for money in
another mental account!
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How much would you pay?
Holiday time! You are in Southern France!
You are lying on the beach on a hot day!
A companion has to make a phone call
and gets up to go and offers to bring back
a pint of beer from the only nearby place
beer is sold. A fancy resort hotel! He
says beer might be expensive and asks
you how much you are willing to pay.
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How much would you pay?
Holiday time! You are in Southern France!
You are lying on the beach on a hot day!
A companion has to make a phone call
and gets up to go and offers to bring back
a pint of beer from the only nearby place
beer is sold. A small run-down corner
shop! He says beer might be expensive
and asks you how much you are willing to
pay.
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Acquisition vs Transaction Utility
Acquisition Utility
a measure of the value of the good relative to its
price
Value as a gift minus the price
Transaction Utility
Perceived value of the deal!
Difference between amount paid and reference
price
 If you pay £5 for a pint from the resort but only £2.5
from a corner shop, you will miss the same pleasant
feeling of drinking beer lying on the beach on a hot day!
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Riding losers too long
Shefrin and Statman, 1987
we discussed last week
Odeon, 1998
trades of individual investors
likely to sell stocks that increase in value
Closing an account at a loss is painful
you might feel regret!
People are reluctant to sell securities at a
loss!
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Who would buy another ticket?
You bought tickets for the Musical Chicago for
£45. On the way to the theater you lost your
ticket. Would you buy another ticket and go
anyway?
You are on your way for the Musical Chicago.
Tickets for the show are £45. On the way to the
theater you lost your purse and your £40 in it.
You have your debit card with you. Would you
buy another ticket and go anyway?
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Sunk Costs
Mental accounts
Buying another ticket is difficult because it is
included in the mental account for the theater
outing. The loss of money is not in that account!
Arkes and Blumer (1985)
Season tickets to a campus theater group
• one group pays full price
• one group receives 13% discount
• one group receives 47% discount
Who attended more plays?
Is there any difference during the second season?
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What would you do?
You have just won £30!
Now chose between
%50 chance to gain £9
%50 chance to lose £9
No further gain or loss
You have just lost £30!
Now chose between
%50 chance to gain £9
%50 chance to lose £9
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No further gain or loss
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What would you do?
You have just lost £30!
Now chose between
%33 chance to gain £30
%67 chance to gain nothing
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No further gain or loss
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Prior outcomes and risky choices
Prior outcomes affect risky choices
Prior gain >>> risk seeking
prior loss >>> risk aversion
unless there is a chance to break even!
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Combine all the points
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Narrow Framing
Equity premium puzzle
• Benartzi and Thaler, 1995
• Mehra and Prescot, 1985
Equity premium in the US is about 6%
1 dollar invested in 1926 worth $1800 in 1998!
the level of risk aversion that can explain this
• is 40 (log utility function 1)
If people rebalance portfolios once a year they
will be indifferent between stocks and bonds!
Myopic loss aversion!
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Narrow framing
Myopic loss aversion
remedy for excessive risk aversion is
aggregation
• either through time or across divisions
Cab drivers
establish a target level per day
quit early on good days!
Mental accounting one day at a time!
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Is mental accounting good for us?
 “I started a little side savings account eight years ago. During the day I
try to accumulate change. If I spend $4.50 at a store, I give the cashier
a $5 bill, even if I have 50 cents in my pocket. At the end of each day
the money is put aside. I add income tax refunds, money from products
I purchased and returned for a refund…. I end up painlessly saving
between $500 and $1000 a year”
A reader of Wall Street Journal giving tips about how he saves money!
A rational economist
would argue it would be less painful to write a check
once a year and send to his savings account!
In reality
Mental accounting matters!
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