Anchoring and Mental Accounting and Why We Do Them

Essay Questions #9
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1. What is anchoring? Explain the social security number experiments. Explain the number of countries from Africa in UN experiments.
Anchoring refers to the utilization of irrelevant information as a basis for measuring or calculating the uncertain value of a financial instrument.
The social security number experiments.
In this experiment, 55 students were asked to write down the last two digits of their social security numbers, in addition to whether they would agree making some payments using the same numbers to purchase some electronics and wine. Also, there was some emphasis on whether they would indeed make these payments. The results showed that those who had a higher number made the highest bid, compared to those with a lower number, who made the lowest bids.
Participant African nations in UN experiments
A when was designed, with numbers starting from 1 to 100. It was then spinned before an audience that was thereafter asked about the number of countries therein from Africa. Those who saw number ten on the wheel were a median of 25%. Those who saw one hundred on the wheel were a median of 45%. The experiment was clear testament that even numbers that are clearly meaningless can still play a key role in anchoring.
2. Why do we do anchoring?
It is done because it provides a rough estimate in determining the specific value of an asset by calculating the uncertain value of a financial instrument.
3. How can anchoring impact finance? How can anchoring impact real estate? Use examples from the slides in your answers.
IPOs derive their starting prices as a result of anchoring. It is also used in valuation exercises in finance, for instance, the starting values and the growth rates.
Anchoring in real estate is used in the context of real estate appraisals.
For example, in slides 193-194, there was a random selection of two groups of real estate agents. These two groups were taken to go and perform some appraisal of a certain house. They were furnished with identical information and everything surrounding them was also quite identical. Perhaps the only different thing between these two groups was the price list. One was given a price list of 65,900 while the other was given one of 83900. There was clearly a difference of 18000 between the price lists of these two groups. The average list of the 1st group was 67,811, and that of the second group was 75,190. The appraisal was 10% higher because of the anchor.
4. What is mental accounting? Explain the lawnmower experiment. Explain the Boston Celtics example.
Mental accounting refers to the categorization of economic and financial decisions. Investors are expected to treat every dollar as of interchangeable value rather than putting money into different accounts and treating them differently.
The lawnmower experiment.
The experiment is about two instances whereby a person has a chance to purchase a more advanced and effective lawnmower type A305 at $2,250.Compared to the initial common lawnmower type A300 that he intended to buy at $2000. In the first instance in part A, the person gets lucky enough and wins $500 in gambling. Therefore, after getting the $500, what is the probability of him buying the A305 lawnmower?
a.100%
b.50%
d.0%
The second instance in part B is that he gets unlucky to win in gambling. Fortunately, he discovers a $500 check in his jacket pocket and realizes that it was a gift given to him by his mother on a rainy day. He arrives at the lawnmower shop and still realizes a more advanced lawnmower, A305, at $2,250.What is the probability of him buying the A305?
a.100%
b.50%
c.0%
Most people will buy the A305 lawnmower in part A. Just because it was money won from gambling. While no to Part B. Just because it was a check from his mom for a rainy day. This is due to the mental accounting effect where people tend to view dollars differently, from different sources, even though money is fungible.
Boston Celtics example.
In this experiment, they organized a sealed bid auction for tickets to Boston Celtics during the Larry Bird era. Half of the participants were told that whoever won the auction would have to pay cash for the tickets within 24hours. Hence, the person who won the right to buy the ticket would be the one that bid the most in cash.
The other half was told that they would have to pay for the tickets within 24hours with their credit cards. Hence the person who won the right to buy the tickets would have to pay for them with a credit card. But what happened is that the average credit bid was twice the average cash bid.
This illustration shows that people put money into separate accounts when presented with a financial decision. They tend to value cash more highly than credit card remittances, despite being all the same amount of money. The cash account is considered a current asset, while a credit card is a future income. Thus, bidding more with credit cards is because people don't value future income as they do current assets.
5. Why do you think we do mental accounting?
We do mental accounting because it is part of human nature to be obsessive about the short-term results rather than the future income. We tend to focus much on the present benefits, value them and disregard the future income no matter how tremendous it may be.
Another...