Mental Accounting – Basic Mantra

Here is a very interesting article I came across in the Economic Times – Do read and let me know how do you do MENTAL ACCOUNTING. :)

Recently we witnessed a Kaun Banega Crorepati (KBC) episode where the participant who had won Rs 1 crore went for the Rs 5-crore question. He had a lifeline and had already become a crorepati, yet decided to go for the kill. Sadly, he got the answer wrong and went home with just Rs 3.2 lakh. It is disappointing to see a person who made Rs 1 crore losing it the next moment because of the decision that he took. Not just this gentleman, there are many others on the show who fell prey to the phenomenon of ‘mental accounting’.

Mental accounting is nothing but the way we decide to treat money differently because of its source. Just because the money was earned in 15 minutes, the participant decided to treat it differently. I am certain they would not bet a tenth of that amount on the same question if the money had come from their paycheque or profession. Not just KBC , mental accounting is at work everyday in almost every financial decision we make. It makes us mentally segregate money into different accounts — such as savings, EMIs, eating-out money, vacation money, gift money or even gambling money.

There are some common examples of mental accounting. A person who gets a bonus and thinks that it is free money and makes a spending plan for it, people who keep money in savings accounts and current accounts and yet have other high-cost personal loans or credit-card loans, people who think that a Rs 300 book is expensive yet spend the same amount in 15 minutes, playing games in a mall, high-tax bracket investors going for an 8% pre-tax return bond while ignoring 7% post-tax options in the debt space. Business owners who link a majority of their wealth to their business or even corporate executives falling in love with their Esops or stocks do need to take care of mental accounting.

Mental accounting can be good sometimes when we earmark a certain portion of our income towards savings or create a savings budget; but more often than not, it leads to self-destructive financial habits or poor financial decisions. According to traditional textbook theory of economics and finance, mental accounting should not exist as money is fungible, which means that a rupee in hand will have the same value and utility as that in a bank account. However, real life is different and our mind creates different mental buckets, where it’s difficult to pay off a loan with the money one plans to buy an LCD.

Thus, mental accounting is a powerful phenomenon and must be worked to one’s advantage to gain from it and avoid costly mistakes. Here is how to do it.

Train your mind to believe that all money is equal and you will not treat money differently depending on its source. As soon as you receive money from a bonus or a windfall, do not make any financial decisions. Let two or three days pass and let the euphoria settle a little. Take stock of your overall balance sheet and think about your important financial needs. Once you have understood your requirements, do the numbers and take a decision. If you have the itch to spend, gamble or do anything else with that money, set aside 50% of it as savings and spend the rest.

Investors can use mental accounting to their advantage by deciding to set a savings budget every month, creating a goal-oriented asset allocation and reviewing it regularly like a semi-annual ritual. At the same time, if you like to trade and make risky bets, do so with a small portion of your portfolio (3-5%) to satisfy your betting or trading urges.