Paul Cohen

As I discussed in an earlier article that you should read for context, prospect theory has a wide range of implications on behavioral economics. One area in which prospect theory is particularly important is in the domain of mental accounting, which concerns how the way in which we think about and categorize financial activities can influence our choices.

 

Prospect theory tells us that value is reference-dependent. Thus, if we re-frame the reference point, we can modify the value of an event. Richard Thaler’s concept of “hedonic framing” in mental accounting [pdf] builds on this premise and offers four principles to maximize value:

 

 

1. Separate gains
What it means

Since the gain function is concave, we experience diminishing sensitivity to incremental increases. Ten gains of $100 feels better than one gain of $1,000. As a result, we can maximize the hedonic impact of gains by spreading them across separate temporal instances instead of aggregating them into a single event.

 

How to use it

• Give employees multiple smaller bonuses or raises over time (vs. one large bonus or raise)
• Order packages to arrive on different days; give gifts over time or wrapped in different wrapping paper
• Share good news over multiple conversations (vs. all at once)
• Split up pleasurable experiences (e.g., two 20 minute massages vs. one 40 minute massage; eat a bit of a bar of chocolate every day vs. all at once)

 

 

2. Combine losses
What it means

The loss function is convex, and as a result, we experience diminishing sensitivity to losses. A single loss of $10 feels less worse than 10 losses of $1. Thus, we can minimize the hedonic impact of losses by aggregating them into one episode.

 

How to use it

• Pay all of your bills on the same day each month
• Pay all taxes (federal, state, local) on one form and with one check
• Aggregate financial losses into one quarter; exit your low performing investments at once (there’s reasonable evidence that this occurs in practice [pdf])
• Share multiple instances of bad news at one time
• Group unpleasant activities into a single episode (e.g., go to the dentist and get your colonoscopy on the same day)

 

 

3. Combine smaller losses with larger gains
What it means

Since the value function is steeper for losses than for gains, we experience loss aversion. For example, we’re more upset losing $5 than happy gaining $5. The interaction of loss aversion with diminishing sensitivity for gains (i.e., diminishing marginal returns) means that we should integrate large gains with smaller losses to neutralize the disproportionate disutility from losses. For example, we feel better when we get a single gain of $95 than a gain of $100 paired with a loss of $5.

 

How to use it

• Charge small bank fees on the same day as large deposits
• Pay commuter fees out of your salary
• Communicate very good news at the same time as minor bad news (e.g., enhanced employee benefits paired with a 2% increase in the employee’s share of dental costs)

 

 

4. Separate smaller gains from larger losses
What it means

The value function for gains is concave and steepest near the origin. As a result, we should try to experience as many small gains as possible. We’ll miss out on the disproportionate impact of a small gain if we use it to slightly offset a large loss. Instead, we can maximize value by separating the small gain from the large loss. For example, we feel better with a small gain of $5 on one day with seemingly unrelated loss of $100 on the next day than a single integrated loss of $95.

 

How to use it

• Overpay your taxes and get a small refund; oversave for a vacation and return with some money left over
• Issue severance checks on a different day from when someone is fired
• Charge a higher price for a product and issue a rebate at a subsequent date