Mental Accounting is one of the money mistakes that even smart people tend to commit. Understanding this mistake and avoiding it could make you richer.
Behavioral Finance experts say that mental accounting works this way: Let us say you have bought a Rs. 200 ticket to a movie. When you show up at the entrance of the theatre and realize you have lost your ticket, do you buy another ticket? If you are like most people, you would probably think twice. You may still drop down the money, but you will now feel that you paid Rs. 400 for a Rs. 200 movie.
But let’s construct the scenario differently. Let’s say you hadn’t bought the ticket yet, and you show up at the entrance to buy your ticket. Unfortunately, you realized you’ve lost Rs. 200 in cash since you walked from the parking place. But fortunately, you still have enough in your wallet to cover the cost of the ticket. Do you buy the ticket? Again, if you are like most people, you may feel upset about the lost money, but it probably won’t affect your decision to buy the ticket. Why?
Behavioral Finance experts conducted similar experiments. They found that 46% of those who lost the ticket were willing to buy a replacement ticket. On the other side 88% of those who lost an equivalent amount of cash were willing to buy a ticket.
Both scenarios are a loss of Rs. 200. However, in the second scenario you separate the loss of the Rs. 200 from the purchasing of the ticket. In the first you consider the cost of the movie as a total of Rs. 400 and suffer at the high cost.
It is because of the psychological phenomenon known as mental accounting. One of the fundamental concepts in Economics says that wealth in general and money in particular, should be fungible. Fungibility, in a nutshell, means that Rs. 100 in lottery winning, Rs. 100 in salary and Rs. 100 tax refund should have the same significance and value to you since each Rs. 100 has the same purchasing power at the market. But do you treat them in a similar way?
Mental accounting has enormous consequences in your daily life. It affects how you spend money and how you save. It influences how you deal with losses and windfall gains.
How Does Mental Accounting Affect You?
The source of the money affects how it is spent – That’s Mental Accounting
- You tend to dine lavishly with the “gift meal vouchers” given by your company. But you will be dining consciously if you are paying out of your salary.
- You are most likely to spend more with credit cards than with cash.
- You may consider Tax refund as“free money”. In actual terms it is your own money. You will not spend tax refunds, birthday gift money or lottery winnings on essential things like utility bills, school fees, paying off your credit card debt. But you will be more than happy to spend the same money on discretionary items such as vacations or a trendy mobile phone.
Don’t be a victim of ‘Relative cost’
Assume you are going to a super market to buy a laptop. The price is Rs. 40,000. But you get to know that there is another branch of the supermarket, a ten minutes walk away, in which the same laptop is sold for Rs. 39,950. Will you walk down to the other branch?
Let us say instead of buying a laptop you have planned to buy a memory card. The price at the supermarket is Rs. 100 and at the other branch is Rs. 50. Where will you buy the card?
Most of us will make a trip to the other branch for the memory card but not for the laptop. Because we think that the Rs. 50 saved on a Rs. 100 item is better than the same amount saved on a Rs. 40,000 item.
But both these situations are the same. You save Rs. 50 by making 10 minutes walk to the other branch.
Remember that money is money. Rs. 50 saved on Rs. 40,000 laptop is not less money than Rs. 50 saved on Rs. 100 memory card.
How to Face Mental Accounting and Spend Consciously?
- You can use mental accounting to your advantage by spending money out of your salary. Immediately invest the “free money” like Tax refunds, gifted money or any other windfall gains.
- Imagine that all income is earned income.
- Use the free meal vouchers and other gift vouchers to buy essential items.
- Pretend you don’t have a credit card. I am not telling you not to use credit cards. I am saying you should stop and think: would I buy this if I was using cash?
A Successful Practical Strategy
You can have two bank accounts. One for the purpose of savings and the other one for spending.
Every month you need to set aside some amount for expenses as per your budget or previous experience. That amount you need to transfer to your spending account. Balance amount you need to keep it in savings account.
You need to meet all your expenses including your credit card payment from the spending account. You should not spend from your savings account.
In between, if you receive any cash gifts or windfall gains, deposit them in your savings account. If you receive gift vouchers, then transfer the money equivalent of that voucher from your spending account to your saving account. That is your spending limit will not go up by just receiving the gift voucher. So that you will not use it lavishly and use it only on pre-planned things.
When it comes to money, your mind unconsciously plays this trick of mental accounting. You have understood that today. Avoid this money mistake and become richer day by day.
The author Ramalingam K is a Certified Financial Planner and an MBA (Finance). He is the Founder and Director of Holistic Investment Planners, a firm that offers Financial Planning and Wealth Management Services. He can be reached at ramalingam[AT]holisticinvestment.in.