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Saturday, November 19, 2011

Are you suffering from Mental Accounting ?

Do you know that majority of the problems in your financial life are purely because of psychological reasons? We are all humans and are prone to think irrationally at times, due to which, a lot many wrong decisions are taken in our personal finance. Behavioural Finance is the area of finance that combines psychology and finance together and gives you an insight as to how a common man makes mistakes in his decisions. Today, I am going to talk about on its concept called ‘Mental Accounting’.

Mental Accounting

Lets imagine a scenario, which will give you a brief idea on mental accounting .

Scenario 1 : You and your wife visit an electronics showroom with the intention to buy a Laptop. After browsing various products you finalize a nice laptop with the price tag of Rs. 40,000. Just when you were to swipe your credit card, the couple behind you mentioned that another showroom about 3 blocks away (15 min drive max) is selling the same laptop for Rs. 39,800. Will you consider driving 15 mins to save Rs.200? Majority of us will not do so!

Scenario 2 : You and your wife visit the same electronics showroom to buy 4 GB Pendrive costing Rs.400. However, you come to know that this product is available for Rs.200 at another showroom which is 15 mins drive. So will you now choose to drive another 15 mins to buy this Pendrive? Most of us will happily choose to drive 15 mins to the second showroom.

If you look at both the scenarios, you will notice that both scenario 1 and scenario 2 are exactly the same, they both will save you Rs. 200 and both requires you to drive 15 min. Exactly same, no difference. But most of the people will choose the first showroom only in scenario 1 and will choose second showroom in scenario 2.

Why does this happen ?

Truly speaking, this happens because of Mental Accounting which makes Rs. 200 saved on laptop not a significant amount because its just 0.5% of the original price. Whereas, Rs. 200 saved on Pendrive looks attractive and substantial bargain because its 50% of the original cost.

What is Mental Accounting ?

Mental Accounting is very simple to understand. What makes is a crucial aspect to understand is the different ways we treat money depending on situation and its source. We often concentrate on the situation and the source of money in terms of the amount of hard work we put to get that money and all these points makes us human to fall prey to treat same amount of money in different ways. But coming back to the facts, Money is Money and it doesn’t matter where it comes from!

So, if you earn Rs. 100 from 3 different sources- Lottery, Salary or Tax Refund, all of them should mean the same as they all have the same purchasing power. Forget how you got it; all of that Rs.100 is valuable equally!

Personal Experience of Mental Accouting

Let me share on how I myself was a victim of Mental Accounting. Some 2 years back, when I did my first stock market trade in F&O. I made Rs. 2000 as profit on an investment of Rs. 6000 in the matter of 2 hours (options trading). This increase of Rs. 2000 actually increased my overall wealth, but to me it was ‘Cheap Money’. Naturally, I had made plans to spend this money and I had no 2nd thoughts on NOT spending. The decision to spend money was not at all rational, but it was fast money which came from stock market and it came without any hard work. Mental Accounting was doing its job in my mind!! Carefully evaluating the situation, all what happened here was that my networth went up by Rs. 2000 and I took out Rs. 2000 and SPENT it!

6 Examples of how our personal finance decisions are based on Mental Accouting

1. Treating some money as “Free-Money” or “Loose-money”

Most of us label money based on where it comes from, by doing so the value of that money appears to be less. E.g. if you get food coupons from your company, you will not consider it as cash! At the last company I worked at, it was amazing to see that people didn’t mind paying up to Rs.50 for Food Coupons for friends, but if the same person had to spend Rs. 10 hard cash, he will not be willing to do so. Food coupons have same purchasing power (at least in limited environment) as cash, so one should be treating it in the same way and not being bias just because it’s not in the form of currency. What I really want to know is that what will happen if companies start providing cash equivalent of these food coupons???

Another example can be with the money that we get from tax refunds, cash gifts on events etc…etc… We all in our heads label these as ‘Cash, but not as valuable’. Imagine that you got Rs. 2000 as your tax refund and you are more likely to be spending this money rather than the willingness you would have to spend from your salary. Also imagine that some friend gave you Rs. 1000 as gift voucher, will you even bother researching on what products can this voucher buy??? In the same way, if you earn yourself a bonus of Rs. 50,000; you will be more inclined to spend it on a holiday or for buying some item for the house. Would you do the same thing with the money from your salary??

So the message is clear, don’t label money as ‘salary money’, ‘tax refund money’, ‘bonus money’ or ‘Gift money’. It’s just MONEY!

2. Holding Stocks and Mutual funds with Loss

Mental Accounting is visible in buying and selling of equity products like stocks and mutual funds. Consider a person who bought shares at Rs. 100 each and the current price drops to Rs. 80. He does not consider this as loss until he books it, loss is not existent for him, and it’s just a possibility. But in real terms, that person is actually suffering loss already. The person in this case labels the loss as ‘potential’ and not ‘real’. On the other hand, if the same stock went up from Rs. 100 to Rs. 120, he will be happy and will be telling everybody that how he is in ‘profit’ even though he has not booked as yet. Profits have already happened according to this person’s thinking and this is exactly why many people fail in stock investments.

3. Size of the decision/money involved

A lot of times the size of the transaction also influences our thinking. Imagine that you went to buy a Plasma TV which costs Rs 20,000. You bargain with the vendor and successfully get a discount of Rs 500; it makes you happy and you feel as if you saved something. But do you put any big effort to find out how you can save much on groceries or vegetables? As the transaction size is bigger and bigger money is involved in case of Plasma TV, it clicks your mind that you should try to bargain the price and save as much as you can, but this thinking is not the same in case of small purchases. Even if we are able to save Rs 5 on small transactions, it would amount to Rs 1700 (approx) in saving in whole year and that would be bigger than Rs 500 saved in case of Plasma TV.

While there can be repetitive headache involved in saving that small amount, the whole idea is to communicate that we tend to think differently when there is a big decision and very different when in smaller ones.

4. Earn less interest and pay more interest

Many investors do the common mistake of earning less interest on their FD’s, PPF or Cash in their Savings account, but pay huge interest on their personal loan or credit card interests. For investors, money in FD’s and PPF is ‘safe’ and not to be touched, but in true sense you are earning less on a part of your portfolio and from that same portfolio you are paying huge interest for loans. If you see your whole portfolio as one and single element without labelling parts of it, your perspective will change. Ideally one should clear a liability whose interest rates are higher than the part of portfolio earning lesser interest . But due to mental accounting , this idea does not look fine to many people .

5. Labeling money into safe money and risky money , loosing any money is just loosing

Ajay has Rs 1,00,000 in Bank FD, Rs 2,00,000 in his PPF account and 5 lacs in Balanced Mutual funds. All these investments are for his daughter’s education down the line and he has mentally labelled it as ‘safe’. However Ajay has also separated out Rs 50,000 to try out stock trading which is his passion and what he loves to do. He has mentally labelled this Rs 50,000 as ‘Risky’. You can see his total worth is 8.5 lacs.

Case A: Now imagine he is in loss of Rs 25,000 in his stock trading. This will not hurt him so much as he had accepted from start that it’s for stock trading and loss was a possibility. He is fine with this loss, as nothing has happened to his ‘safe’ investments.

Case B: Suppose market is down and he faces a loss of Rs 25,000 on his mutual funds. As the loss has happened in his mutual funds which was initially labelled as ‘safe’ and “for-his-daughter’s-education”, the level of disappointment and worry would be much bigger than Case A.

Even though the reaction of Ajay was different in both case A and case B, it’s purely because of mental accounting and the way he had unconsciously labelled both investments of his portfolio, but in both the cases the reality is that his total net worth went down from 8.5 lacs to 8.3 lacs, It’s as simple as that.

6. Paying for Financial advice

We recently encountered a very funny situation, one of the readers contacted us for our Financial Coaching service, he was very clear that he needs it (For readers who are not aware about financial coaching, it’s a paid program where we coach people in their financial life just like Garry Kirsten coaches Indian cricket team and transformed their performance). He was very much interested in being coached on his finances and what MONEY means to him, but was very uncomfortable paying the fee out of his wealth, as for him there were other important things in life; he said he would get back to us once he makes the decision. But he didn’t communicate for weeks, then just last week he told us that now he is ready for Financial Coaching. After we started his work, we asked him, what had happened in his life which motivated him to take our service. To our surprise, he had sold his old car and got price way beyond he expected, and he was fine to use that extra money to improve his financial life.

If you look at this incident closely, even the money which he got by selling his old car become the part of his overall wealth, the moment he sold it, in fact it was always part of his wealth even when he didn’t sold it. You must be thinking what was our first coaching lesson for him? Yes, it was the way he looks at different aspects of his financial life and not fall prey to these kinds of behavioural patterns.

7. Treating unexpected money in a different way

There are lot of unexpected money at times coming in our life , It can be money in form of Bonus from your company , It can be money recieved from an old friend who took it from you ,didnt give back to you and you also forgot about it. It can be some money you find in old book which you had secretley kept long back . All these are examples of “unexpected” money and hence there is no mental accout for it , that money looks more of pocket money to you and you tend to spend it without thinking much .. However money is money , no matter from where it came . Its just different in your mind .

Please share your real life incidents where you fell prey to mental accounting . Do you think mental accounting is not applicable in real life and is more of a “time pass” concept or do you think its really something one has to understand and apply in their financial life ? Share your views

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