Mental Accounting
A concept first named by Richard Thaler (1980), means that people mentally frame assets as belonging to either current income, current wealth or future income and this has implications for their behavior as the accounts are largely non-fungible and marginal propensity to consume out of each account is different.
https://en.wikipedia.org/wiki/Mental_accounting
Mental accounting refers to the tendency for people to separate their money into separate accounts based on a variety of subjective criteria, like the source of the money and intent for each account. According to the theory, individuals assign different functions to each asset group, which has an often irrational and detrimental effect on their consumption decisions and other behaviours.
https://www.investopedia.com/university/behavioral_finance/behavioral5.asp
People usually consider and treat the funds that arrive from different sources, differently.
For example, we may find difficult to spend the salary amount to buy an expensive gadget, but, when we receive a bonus we may end up using it to buy that gadget.
This is because, our mind thinks the sources of funds are different, one comes from our paycheck which we get after a month of tiresome work, and the other – the bonus – comes as a gift or a windfall gain.
Actually, both the sources of money are coming from our efforts at work and should be treated the same way.
Similarly, people find difficult to pay anything by cash and instead ready to swipe the credit or debit or gift card for the same amount or ever more.
This is because, when you see money going out from your wallet, it is painful. Instead during a card purchase you don’t see the money movement and hence no pain.
Actually, you are anyway going to pay the card debt some time later – even worse, if you miss the payment on time, will have to pay with interest.
We come across people who have a few lakhs in Fixed Deposits and Savings Accounts, but holding a home or car loan or even a pending credit card debt at a much higher interest rate.
Ideally, they should break the Fixed Deposits and Savings Accounts and pay off the high cost debt (may be after keeping some for emergency purposes).
Mental Accounting in our daily life – few examples
Assume you have bought a movie ticket for Rs.100. When you reach the theatre, you realise that you have lost the ticket. Would you buy another?
Assume that you want to watch a movie and go to a theatre and when you go to the ticket counter to buy a ticket, you realize that you have lost Rs.100 in cash. But, you still have money to buy a ticket.
Research says that most people will not buy a ticket in scenario 1 and willing to buy a ticket in scenario 2.
Both scenarios are same and incurred a loss of Rs.100. However, in the second scenario you feel you haven’t bought a ticket and have not yet spent the money for the movie. But, in the first case you have already spent the money for the movie, and hence not willing to buy another ticket.
Assume you go shopping and you find reading lamps in various sizes were on sale. Usually, the price differs as per the size of the table lamp set. But, in this sale all lamps sets are on sale for the same price. Which one would you choose? Most people would choose the larger ones, even though they may have a very small size reading table at home. Because, our mind perceives a ‘larger’ savings in buying a larger piece.
Assume you want to buy a cellphone and a laptop and you are shopping. You find the cellphone priced at Rs.5000 and a laptop priced at Rs.50000. The salesman tells you that if you drive down a few miles they have their factory outlet where the prices are Rs.1000 lesser on all products.
Will you make a trip to the factory outlet. Most people would make the trip for the cellphone and may not for the laptop as Rs.1000 saving on Rs.5000 item seems larger than on Rs.50000 item, even though both Rs.1000 are same in savings.
Similarly, people tend to spend Rs.1000 tax refund on a dinner, and consider Rs.25000 tax refund as a huge amount worth saving, even though the source is the same and it’s our money.
Mental Accounting In Investing
Similarly, in investing people tend to have different portfolios – one core and another for trading.
They use their salary savings for core portfolio, and money from dividends, bonus, tax returns etc., are used for trading, even though everything is their money and should be given equal weightage.
Consider an investor who bought shares at Rs.100 and the price drops to Rs.75. Until he sells the stock, he will not consider it a loss. But, in real terms, it is anyway a loss on his networth. But, if the stock reaches Rs.150, he will feel happier, and will tell everyone that he has made a profit, even though he has not yet sold them.
How to know if you have fallen for Mental Accounting?
- You have a few lakhs in Savings and Deposit accounts, while carrying high cost debt
- You spend more with credit cards than with cash
- You usually spend whatever you receive in windfall or other means like tax refunds, lottery, dividends etc.,
- Tendency to value money differently depending on where it comes from
How to overcome Mental Accounting?
- Avoid dividing money into different mental accounts
- Understand that all income is hard earned income
- For every purchase, as yourself if you will be giving cash down right to buy it
- Recordkeeping of all incomes and expenditures and check them regularly
- Regularly check your savings and investments VS debts to pay
- Do not receive anything in cash. Get them directly credited to your savings account.
My experience with mental accounting
During my early days of investing, I used to get dividends and interests on deposits credited to my account, and usually end up spending them on dinner or some gadget purchases.
Later, I have practiced to save the dividends and once they reach a decent amount, I will reinvest in the markets. Similarly, I have opted to get all my deposits in auto renewal mode – that is, once deposits are matured, both the principal and interest put together is reinvested again in a deposit.