Mental Accounting
(Related to our emotional state)
I personally think that money is a very important part of human life without money it is very difficult to maintain human financial needs. It is very much required for daily living expenses & needs, but sometimes investors ( all humans like) take irrational decisions about the money. Why this? In this blog we try to understand the following question in our mind:
- Why do we take irrational decisions related to money in their spending and investment behavior?
- Why this happens and how to avoid or stop them?
Let's first, understand, What is money? Money is nothing but a medium of exchange and it acts as an intermediate in the exchange process. A person holding money can easily exchange it for any commodity or service that he or she might want.
It is a human tendency to link money to a particular purpose (expenses/savings) and also take decisions, for money based on where the money comes from (i.e.salary, lottery or bonus, tax refund, gift, etc.) means to take decisions based on its origin or use. This concept is called "Mental Accounting".
Now we understand what is Mental accounting. It is the concept, "Humans take irrational decisions due to put different values on money based on subjective criteria". You can understand its simple terms as, it's a human habit to give mental labels for money based on where this money comes from (i.e salary, lottery or bonus, tax refund, gift, etc.) and takes financial decisions based on these.
The concept of mental accounting was developed in 1999 by Nobel Prize-winning economist Richard Thaler and refers to values people place on money, based on subjective criteria. He recommended that people treat money as a fungible commodity and treat all money equally, regardless of its origin or use, to avoid mental accounting. or in simple terms, we say all money is the same it does not matter where the money comes from (i.e salary, lottery or bonus, tax refund, gift, etc.)) or what has been set out to use (i.e living expenses, travel expenses, investment, saving, school expenses, etc.)
Let's try to understand Humans take decisions related to money for its origin or use. for example when you get a tax refund, you think it is "found money" and spend it without planning but in actuality, it is the money refunded to you by the income tax department for over tax payment, not a gift & you treat it as the same way just like salary or regular income means.
Consider one more situation, people having money in a saving account and getting less interest while simultaneously holding credit card debt where the interest rate is too high.
By dividing money into different levels we can bind ourselves into inflexible budgets, where we can not differences between our expected and actual expenses. A great example of this is the actor, Dustin Hoffmann. See the video
Dustin Hoffman’s Mental Accounting.
Source: YouTube
- Earned Income Vs Gift Income
- Quantity of the money in question
- Large purchase vs small purchase
- Cash vs credit card
Earned
Income Vs Gift Income
When you earned the money from your salary or work you did that money
is got from your hard work. But if you get a gift of the same amount of money you
would treat it differently. You may spend it with an open heart. Mentally to you, this is
free money but your earned come is not. You earned it hence you put it into a
different account.
Quantity of the money in question
We create
mental accounts according to the quantity of the money and treat them
differently. For example, if you got a tax refund of 1000, you are likely to spend that
without giving it due thought. But a tax refund of 20,000 will set up thinking about whether to deposit it in a bank or invest. Because small amounts go into the
miscellaneous account and big amounts go into the important decision account.
Large purchase Vs small purchase
Many people are cost-conscious when making
large financial decisions but they relax their discipline when it comes to
small purchases.
Cash vs. credit cards
It is a big
profit earner for the bank and a hole in the pocket of the user who is not
aware of the harm it can cause.
Mental accounting has benefits also:
- By assigning money for the purpose of its use it provides you to look after and disciple yourself about money.
- Help us to balance money with our needs and desires. for example
You can avoid mental accounting which is really a very difficult task, but with planning and remembering the following points in mind to overcome this:
- Take money as a medium of exchange, no matter where they allocate it for example your daily expenses need or saving / investments.
- Treat all money as earned money.
We feel that Mental accounting is neither good nor bad in itself. it will depend upon your behavior on money. Its effects can benefit you in life, but it can also make your decisions less accurate and irrational.
Disclaimer: This blog is exclusively for educational purposes and does not provide any advice/tips on Investment or recommend buying and selling any stock
