Mental Accounting

"An investor whose decisions are impacted by mental accounting will look at investments as separate, focusing on the risk of investments in isolation. This means that the investor dismisses the effects of correlation, thus leading to more risky portfolios than an investor who does consider correlation. " It seems to me this could be argued either way. If an investor isn’t considering correlations, then the investor is ignoring diversification benefits, and so may take less risk than otherwise because of the high appearance of risk (in isolation of diversification benefits). Thoughts?


I agree with you. I remember a q along those lines, I got it right but found it frustrating to answer. Probably a time when you just have to give the answer they want. Here’s how I approached it: I think that in either case, his understanding of risk is off, and thus he is more likely to concentrate in specific risks. Put another way, if a combo of stocks (R=15%) and (bonds R=5%) is used to get a 10% return, a mental accountant would put all his assets in an asset with a lower beta at 10%, which would have a much higher risk in a mkt correction than a bond/stock p’folio.