Does Mental Accounting Matter in Portfolio Management? A Prospect Theory Application

Do the propositions of mental accounting matter in investors’ portfolio management? In assisting the investors in their portfolio management, this study explores if the separation principle in mental accounting (MA) can be applied in their portfolio decision choices. It also examines if investors prefer an individual stock to the portfolio of stocks for investments. With the use of daily market prices data during a twenty-year time period for nine NSE Nifty sample stocks and their portfolio as well, this study applies the prospect theory (PT) decision references in the non-linear autoregressive distributive lag (NARDL) models. It also performs robustness checks with t-tests for differences between the coefficient magnitudes in the models. At PT implications with the variables for market premium, systematic beta and isolation effects, the separation principle of the MA theory matters in the portfolio management for stocks’ returns and market return. Investors’ psychological effect is found to contribute to their preferences amongst the sample stocks for their inclusion in the portfolio. Ingenious applications of the PT views on MA in portfolio management reveal the presence of synchronicity in terms of long-memory and short-memory effects on returns of the stocks and portfolio as well. Even if the generalizability of the stated findings is subject to its sample size, this empirical exploration with the Indian stocks market data shows original contribution in mental accounting and its use to explain the equity premium puzzle could enhance its applicative value.