Professor Richard Thaler is one of the leading figures in the Behavioural Finance academic world and has been credited with the term “Mental Accounting”. Here is one of my favourite mental accounting bias examples used to describe what is a very common situation among traders..
Las Vegas here we come…
A couple go to Las Vegas on honeymoon and after an enjoyable evening of dinner, theatre and some bedroom activity Joe decides to soak in the night air by smoking a cigar on the balcony of their suite. After what seemed like a short break Joe discovers that Sophie is fast asleep. On his way over to kiss his gorgeous wife good night Joe puts his hands in the pocket of his green hotel bathrobe and discovers a casino chip in his pocket. It has the number 17 on it and an inner voice starts speaking to him, “Joe, this is the one.” Without wasting any time, Joe is off to the casino with his lucky number 17 chip.
$268 million riding on 17 – What happens next?
He puts the $5 chip on 17 and up comes 17. Next spin he puts his winnings on 17 and again it comes up. Joe repeats this routine a number of times until he reaches the maximum bet the casino will take; he now has $268 million riding on 17 and after what seems like an eternity the ball lands on 18. Joe has lost it all. With the little bit of energy left in him, he walks to his room and flops on the bed. His beautiful young wife Sophie wakes up from her sleep and asks Joe where he has been. He responds that he was gambling, so she asked how he did, and he said “not too good; I lost $5.”
Mental accounting at its best
This example illustrates how we compartmentalise our finance. Joe put the $5 and then the subsequent $268 million in a separate compartment from his wealth. To him it was never really his. The very same kind of mental accounting happens when we receive a refund from the taxman that was somewhat unexpected. Instead of absorbing the new money into our existing pot, we somehow see this new money as a windfall and worthy of extravagant spending, which is different from how we would treat our own money. I hope you can start to see how this error in judgement could have disastrous effects when approaching trading. I am sure none of you have treated the profits made on a trade as winnings to have a full go with ?.