How do you keep mental account of gains, losses and regret? – Chapter 32

For most people, gaining money reflects achievement and self-regard. We keep score in our mind when we lose or gain money and consider them punishments and rewards, threats and promises. The ‘scores’ motivate our actions and influence our preferences. Cutting our losses feels like a failure, so we refuse doing it.

We hold money in both physical and mental accounts. We have general savings, special savings for our kids or emergencies and money to spend. We are more willing to draw on some of these accounts compared to other accounts to cover current needs. Self-control also plays a role: some accounts can be used only for household expenses, they limit have much we can spend. Mental accounts are a form of narrow framing: they keep things manageable and under control. Mental accounts are used for keeping score. For instance, successful golfers have a separate account for each hole, not just one for their overall score.

Consider the following example of mental accounting. Two Rihanna fans have to travel 50 miles to visit her concert. One of them bought the ticket, the other one got it as a gift. A heavy snowstorm is announced for the day of the concert. Which of the two fans is more likely to brave the storm to see Rihanna? The fan who paid for the ticket. Both of them set up a mental account for the concert they hoped to visit. Missing the concert will result into a negative balance. Both will be sad, but the closing balance is more negative for the fan who paid for the ticket. System 1 performs the calculations of emotional balance. For System 2 to respond rationally, it would have to be aware of the counterfactual possibility: “Would I still travel in this blizzard if I had gotten the ticket as a gift?” This requires a disciplined and active mind.

Imagine an individual investor having to sell stock because he is in need of money. He still remembers the price at which he bought each stock and can identify it as a loser or a winner. Fafsung is a winner: if he sells it now, he gains € 8.000. He holds an equal investment in Fapple, which is now worth € 8.000 less than he paid for it. In the last month, the value of both stocks has been stable. Which is he more likely to sell? Closing the Fafsung account results into an positive score. Closing the Fapple account would lead to a negative score. He has to choose between pleasure and pain, so he will likely sell Fafsung. Financial research shows that there is a major preference for selling winners. This bias is called the ‘disposition effect’, which is an example of narrow framing. The state of the mental account was considered a valid consideration for selling. If you care more about your wealth, you would sell the loser.

Imagine a firm that has already spent € 20 million on a failing project. The forecasts are worse than at the starting point. Another € 40 million is needed to give it a chance. The alternative is investing the money in a new project that appears to have a brighter future. What will the firm do? Companies often refuse to accept the humiliation of closing the account of the failure and invest more money in the failing project. In light of the fourfold pattern: this represents the choice between an unfavorable gamble and a sure loss. The sunk-cost fallacy keeps people too long in unhappy relationships, bad jobs and unpromising projects.

When do we feel the most regret?

Regret is something we consider a punishment. The fear of regret is a factor in a lot of decisions we make. Regret is triggered by the availability of alternatives to reality. Regret differs from blame, but both are induced by a comparison to a norm.

We tend to feel greater regret we experience after acting than after failing to act. Consider this example: “Anna considered switching employers, but decided not to switch. She learns that she would have been better off € 2.500 if she had switched. Claire has switched employers and learns she would have been better off by € 2.500 if she had kept her job by her former employer. Who feels the most regret?” Most people would say Claire, because she acted. People expect to have stronger emotional responses, like regret, to an outcome produced by action than by inaction. This is also found in the context of gambling.

When it comes to the endowment effect, reactions to price changes and choices between gambles, losses are weighted approximately twice as much as gains. In certain situations, the loss-aversion coefficient is a lot higher. An example is health. Consider the following problem. “You have been exposed to a disease, which if contracted leads to a rapid and painless death within 4 days. The probability that you contracted it is 1/1.200. Before symptoms occur, you can get an effective vaccine. What is the maximum you would be willing to pay for it?” The majority of people would be willing to buy a limited amount. The risk of dying is small, it appears unreasonable to pay a lot of money in order to avoid it. Now consider the following problem: “For research on diseases, you are asked to expose yourself to a 1/1.200 chance of contracting the disease. What is the minimum you would ask to be paid?’ Most people set the fee much higher than the price they were willing to pay for the vaccine (ratio of 50:1). The high selling price demonstrates two features of the problem: we are not supposed to sell our health (is viewed as not legitimate, thus people are reluctant to participate) and more importantly: you will be responsible for a potential bad outcome. You will feel more regret in the second case, because you could have done nothing. Another example is the reluctance of parents to expose their child to a danger for a few seconds in return for money. The intense aversion to trading increased risk for a benefit is also found in European laws (precautionary principle: actions that might cause harm are prohibited).