A Study On The Relationship Between Mental Accounting And Anomalies

In the traditional view of economic research, economists nearly always adopt the rational framework to analyze the behavior of human. However, in reality, especially with financial activity becoming the economic center, many experts find some phenomena that deviate from the classic finance theory-Anomalies. In "Understanding Modern Economics", Pro.Qian(2002) argues that the values of theories are not from their directly explanatory power to reality, but to provide a frame of reference for explanation. Therefore, it means that it needs new theories when the traditional theories can not explain the phenomena from realities. In 1979, Daniel Kahnemann and Amos Tversky published their milestone paper "Prospect theory: an analysis of decision under risk" in Econometrica, which marks the birth of Behavioral Finance, one important branch of modern finance. So a new analytical paradigm loomed large to meet the requirements.Indeed, the significance of the new theories or paradigm lies in the strong explanatory power to the economic phenomena in reality. With the classic finance theory being the mainstream, lots of anomalies emerged such as Friedman-Savage paradox, house money effect, portfolio choice problem, equity premium puzzle and dividend puzzle. The classic theories have so tiny power to explain these anomalies, on the contrary, mental accounting in behavioral finance do a good job, which is the springboard of this paper.Mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities. Mental account was initially put forward by Tversky and Kahneman(1981). After that, Thaler (1985) coined the term "mental accounting". Based on the introduction of behavioral finance, the paper put focus on mental accounting approach to explain anomalies effectively. By comparing the traditional and behavioral finance approaches, this article argues that there is a large room for the development of the behavioral finance especially the mental accounting theory.