Here’s a teaser:

Case 1: Imagine that you have decide to watch a movie tonight and you already purchased a ticket for $10. As you enter the theater, you discover that you have lost the ticket. The ticket office tells you they keep no records so you will have to purchase a new ticket to see the movie. Would you still pay $10 for another ticket?

Imagine that you have decide to watch a movie tonight and you already purchased a ticket for $10. As you enter the theater, you discover that you have lost the ticket. The ticket office tells you they keep no records so you will have to purchase a new ticket to see the movie. Would you still pay $10 for another ticket? Case 2: Imagine that you have decided to watch a movie tonight and the ticket is $10. As you enter the theater, you discover that you have lost a $10 bill on the way. Would you still pay $10 for a ticket for the movie?

Between both cases your answers should be equivalent: you’ve lost $10, either in the form of a $10 bill or a $10 ticket. But when psychologists Kahneman and Tversky (1984) asked survey respondents these questions, far more people were willing to buy a new ticket in the second case.

It turns out that a dollar isn’t a dollar. People tend to build different budgets in which spending is treated differently. So, while people were treating the second case as just losing a separate $10 from their general net worth, they were treating the first case as spending $20 on the movie — which feels like paying more than in the second case.

The same bias applies to investing: behavioral biases make us panic more than we rationally should, or act in ways that contradict our beliefs.

These are some case studies that I’ve encountered:

Years ago, A. bought several Bitcoins at $400, and lost it all due to an exchange scam. At $5000, he thinks that the price of Bitcoin will rise, but is reluctant to buy or mine Bitcoin because he’s already “spent too much money on cryptocurrencies.”

While lessons can be gleaned from a former loss is a good reason to improve your security, or use physical wallets, your current investment decisions should be independent of a previous loss in the same domain.

C. bought Ethereum at two price points: $200 and $400. Believing that the price of Ethereum might dip below $400 because of a news event, she sells only the tokens she purchased at $400 so that she “wouldn’t lose on any part of her portfolio.”

Tokens are fungible: a token bought at one price is the same as one bought at another. Your decision of how much to sell should be independent of the price you bought tokens at, but dependent on how certain you are of the price movement. Regardless, even experienced investors base decisions on transaction utility instead of the bottom line (Thaler 1985).

D. is convinced that the value of Bitcoin will rise over time. However, she feels that it is “too late to get in” as the price has already risen by a lot.

During a rally, prices may be anchored to its previous price history. The investment becomes perceived as a loss against what she could have gained in retrospect — even though the investment would still be a net gain.

F. is convinced that the value of Bitcoin will rise over time. However, the price of Bitcoin suddenly falls because an exchange was hacked. While still convinced of the long-run value of Bitcoin, he panics and sells his Bitcoin until it returns to its previous price.

Investors are known to overweight unexpected, short-term losses, and are known to be impatient in “locking in” prices — even when they result in trading fees or losses.

All of these failure modes are affected by mental accounting bias, among others. When we extrapolate the wrong conclusions from our mental accounts, we fail to make rational decisions on the margin. Even when these biases don’t translate into losses, they take up our attention span and direct us to the wrong questions.

Now that we know mental accounting bias exists, we can use it to our advantage. On a very natural level, we’re using mental accounts to rationalise our investment decisions and manage self-control. We can frame our investment decisions in a way that protects us from the outsized psychological impact of unexpected events and losses, so we can make rational decisions.