6.1.3 Section Summary
In this section I have elaborated on the concept of loss aversion. I have shown two different effects, that both constitute examples of loss aversion. The endowment effect illustrated the fact that if a person has an object in her possession or endowment, the loss of giving up this object caused much more pain than it would have yielded pleasure to acquire it. It was shown, that the individuals’ who already had a mug in their endowment, valued it at approximately twice the price of the subjects who did not posses a mug. That is, the owners’ loss of the mug loomed larger than the choosers’
gain of the mug. The status quo bias showed that, due to loss aversion, people tend to favour their status quo relative to other options if they have to give up something in order to achieve something else. This was graphically illustrated in figure 6.1 and exemplified through an experiment in which it was shown, that even though subjects had the opportunity to exchange the gift received, only 10%
chose to do so. The above-mentioned experiments and examples illustrate that loss aversion, the endowment effect, and the status quo bias are important factors that deserve a fair amount of atten-tion in descriptive analyses of decision, and- choice problems.
consequences for decision making because it leads to a mental segregating of factors that might otherwise have been integrated (Rockenbach, 2003).
6.2.1 Mental Accounting and the Framing Phase of Prospect Theory
We have already seen evidence of mental accounting earlier on in this thesis. The framing phase of prospect theory, described above, is vitally linked to the concept of mental accounting. We might say that a key part of the framing conducted by individuals is setting up mental accounts or associ-ating prospects with existing accounts. Earlier we saw the importance of the fact that individuals base their decisions upon relative outcomes instead of final states. This caused failure of the predic-tions of expected utility theory. The evaluation of gains and losses as separate outcomes is a reflec-tion of mental accounting in that they are posted on different mental accounts. As noted by Thaler (1999), focussing on changes rather than wealth levels as in expected utility theory reflects the piecemeal nature of mental accounting. Transactions are often evaluated one at a time, rather than in conjunction with everything else. So, the determination of the reference point from which gains and losses are derived, which was a key part of the framing phase in prospect theory, results from mental accounting. Individuals will determine, on which mental account the prospect should be booked and as such define the reference point.
6.2.2 Choice Bracketing
As mentioned above a mental account can be very specific or widely defined. To elaborate this im-portant point, I introduce another key concept regarding mental accounting, which is labelled choice bracketing (Read, Loewenstein and Rabin 1999). The concept of choice bracketing designates the grouping of individual choices together into sets, i.e. whether a series of choices are made one at a time or grouped together. A set of choices is bracketed together when the choices are made by tak-ing into account the effect of each stak-ingle choice on all the other choices in a set. Narrow brackettak-ing is defined as the situation where sets are small and thereby only consists of one or few choices.
When the sets are large, this is defined as broad bracketing. Moreover, choice bracketing refers the frequency with which mental accounts are evaluated, i.e. how often the reference point is reset.
When choices are bracketed narrowly (broadly), the accounts are evaluated frequently (less fre-quently). A bracketing effect arises when outcomes chosen under narrow bracketing differ from those chosen under broad bracketing. So, when making many choices, the decision maker can either bracket them broadly by assessing the consequences of all taken together, or narrowly by making each choice in isolation. Because broad bracketing allow decision makers to take into account all the consequences of their actions, it generally leads to choices of higher utility than if the choices
are bracketed narrowly (Thaler 1999). Because of this Thaler uses the term ‘myopia’ for narrow bracketing since “the frequent evaluations prevent the investors from adopting a strategy that would be preferred over an appropriately long time horizon” 29.
The concept of choice bracketing can be illustrated through the following example: Consider the decision whether to smoke or abstain (Read, Loewenstein and Rabin 1999). If choices are made one cigarette at the time, the expected pleasure from each cigarette can easily seem to outweigh the health consequences that appear trivial when evaluated one cigarette at the time. So lighting up the cigarette can be argued to be the best choice. But if 7.300 single-cigarette decisions a year are com-bined (this corresponds to a packet a day), the health consequences might appear less trivial and might outweigh the pleasure. The person who makes 7.300 individually inconsequential decisions to smoke, therefore, makes an aggregate choice that might have been rejected, if all the decisions had been bracketed together30.
Obviously, bracketing too is a part of the framing process, as described above. Or rather, the con-cepts of narrow/broadly framing (Kahneman and Lovallo 1993) and bracketing are used inter-twined.
The cigarette example clarified the concept of choice bracketing and now it is possible to show how narrow bracketing played a key role in the above rejections of the axioms of expected utility theory.
Consider problem 6, decision i and ii in section 4.2. When the choices were presented in this way, the majority of subjects chose the less attractive option, C and F. This, we saw, was due to people being loss averse and giving disproportionate weight to outcomes that are certain. So, subjects were risk averse when making choice i, and risk seeking when making choice ii. But as we noted above, the other combination, D and E, dominated outcomes C and F. So the subjects apparently bracketed the two choices separately and treated each choice as if it had no connection to the other. Had they bracketed the choices broadly, they would have chosen differently. This was seen in problem 5, in which the choices were presented in aggregation and thus were broadly bracketed. Here nobody chose the dominated pair of C and F (i.e. prospect A in problem 5).
6.2.3 Section Summary
In this section the concept of mental accounting have been presented and discussed.
Mental accounting is defined as the cognitive operations decision makers use in order to structure and organize financial activities. A given activity is assigned to a specific mental account and then
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30 Had I only read this article when I was 13!
evaluated in the context of this account. Thus, the mental account is the catalyst for determining how an outcome is perceived and henceforth evaluated. A mental account can be defined in both broad and narrow terms, and it can be balanced frequently or rarely. Mental accounting played a significant role in the framing phase of prospect theory, for instance in decision makers basing their decisions on relative outcomes as opposed to final wealth. Gains and losses are posted on separate mental accounts resulting in decision makers evaluating them separately.
Closely related concepts are narrow and broad choice bracketing. Choice bracketing refers to whether a series of choices are made one at a time or grouped together and it refers to the frequency with which mental accounts are evaluated, i.e. how often the reference point is reset. When choices are bracketed narrowly, individuals evaluate decisions/outcomes one at a time and frequently. When choices are bracketed broadly individuals combine several decisions/outcomes into sets and evalu-ate them less frequently. Broad bracketing generally leads to choices of higher utility because it allows decision makers to implement a wider spectrum of consequences in their decision process.
And this accounts for the term ‘myopia’ since frequent evaluations, i.e. narrow bracketing prohibits decision makers from making long-term strategies.
In the next section, the concepts of loss aversion and choice bracketing/myopia are discussed in combination in order to see how this combination can constitute a plausible explanation to the eq-uity premium puzzle.