What is a mental account and how can we use this principle to derive trading strategies?
1⃣ (Mental Account) In many people’s brains, money is divided into accounts. For example, many people think that they should spend 600 yuan on gas every month, but now they only spend 300 yuan due to the drop in oil prices. Naturally, they think that they have saved so much money at once, so they should spend more money, so they will upgrade to better oil. It is the same when many people invest. You invest in different stocks and invest in different places. In theory, your investment actually diversifies the risks, but in your mind, the risks may not be dispersed.
Because you think that if one stock loses money and another stock makes money, you still want to wait for the losing stock to make back your money. In fact, you made money if you put them together, but in your mind you may treat them separately, failing to achieve the purpose of risk diversification.
In the previous example, you should have seen that people have mental accounts, and they divide different accounts in their brains. However, mental accounts are actually difficult to apply in real life. One important reason is that different people have different mental accounts. Unlike loss aversion, most people have loss aversion, even monkeys have loss aversion, but mental accounts are very different. Everyone's algorithm is different in the brain. Combine mental accounts with multiple investment opportunities to see if some investment strategies can be generated. In fact, the most important idea here is that because everyone's mental accounts are different, everyone will treat book losses and actual losses differently. Although in rational economics and rational finance, book losses and real losses are the same thing.
Research has found that if the previous investment made money on paper, you will want to lock in your profit and be more risk-averse. If the previous investment was a paper loss, that is, you have not yet realized your loss, you will be more willing to take risks and try to recover your investment. Therefore, your risk preference is different for paper losses and paper profits.
2⃣（Trading strategy）
Suppose now, you get all the transaction data from the exchange. You know how much money each stock holder has spent in the past and what the current stock price is. You can calculate the current book profit and book loss of these people, which is a signal.
At the same time, since you have the past transaction records of all people, you know the book profit or loss of each stock in the past year, as well as the realized profit or loss. Of course, if you don't have the data I just mentioned, this is normal, and you can also calculate an approximate value. This is more complicated, and I don't have time to explain it in detail, but if you are interested, you can read some related academic papers.
Now, with these two variables, for example, the first variable is unrealized loss and the second variable is realized loss, how do you make a strategy? Normally, which stocks do you buy? You buy stocks with very small unrealized losses, that is, those stocks with unrealized profits, and short sell stocks with large unrealized losses. This is actually similar to the strategy mentioned above. However, at the same time, you buy stocks with large realized losses and short sell stocks with small realized losses.
Let me summarize briefly. Which stocks should you buy? Buy stocks with small unrealized losses, that is, stocks with relatively large unrealized profits. At the same time, it is best if this stock has a lot of realized losses. These two signals are of course positively correlated, so once you buy this kind of stock, its average return in the future will be much higher. If we only use one signal, only unrealized losses or unrealized profits to implement this investment strategy, the average annual return will depend on different time periods, which is about 6% per year. But if you put the two signals I just mentioned together, your return can basically double.