Marzee Kerawala is a Certified Financial Planner with expertise in Income Tax and Investment products. Managing assets worth over Rs. 4 Billion, his firm ‘NiveshIndia’, designs Tailored Investment Strategy through Customised Financial Planning for individuals and NRIs, and also handles Treasury Management for corporates and SMEs. You can contact him at +91 9987567667 or Email: firstname.lastname@example.org [Website is www.niveshindia.in]
In my last article I elaborated on ‘Behavioral Biases’ investors often fall prey to, which impact their long term wealth creation, thereby providing you with simple yet effective methods to understand, learn and overcome these biases. We discussed ‘Loss Aversion’ bias along and ways to overcome it. In this article, we will discuss Mental Accounting with real life examples. Mental Accounting is a behavioral bias that occurs when people map their money to separate accounts or categories of expenses and investments, based on source(s) of money or its usage. Simply put, it’s about people putting different values on the same amount of money, based on where it is coming from, and where it will be expended.
Mental Accounting proves useful when we earmark a certain portion of our income towards specific expenses, or certain investments towards specific financial goals. As a kid, I still remember my father getting his salary on the 3rd of every month; he used to get hard cash and my mom used to first keep the cash in various envelopes marked – ‘School Fees’, ‘Groceries’, ‘Rent’, ‘Electricity’, ‘Telephone’, ‘Maid’, ‘Medical Expenses’, ‘Shopping’, etc. Mostly, by end of the month, the cash in the ‘Grocery’ envelope would get over and she’d ask for replenishments from dad. When he’d try to reason why she needed cash when the ‘Medical Expenses’ and ‘Shopping’ envelopes were almost full, she would point to and open the empty ‘Grocery’ envelope! This clearly tells us that in minds of human beings, cash or even investment, is not fungible/interchangeable.
To understand it better, I have done this experiment with my own spouse! When there’s a wedding or Navjote within our close family, we often go shopping for clothes, shoes, accessories, etc. I’ve always noticed that if you list out the items you actually need and go to respective standalone brand shops to buy them, you will end up buying things which you require and it will be less expensive, than when you visit a mall with over a hundred brand shops in it! We tend to buy things which are not in our buying list just because they are accessible with ease and available at the convenience of one location.
Moreover, I have now started to give her cash or carry cash for shopping. It is observed that more impulsive buying on a shopping trip was attributed to the use of credit/debit cards. Earlier, when we used to shop around carrying cards, we used to spend much more, compared to when we spend hard cash. Though the amount of money spent on cards as well as cash may be the same, paying with a credit/debit card is less painful, as the actual parting of money in credit card happens at a much later date, while giving away hard cash on the billing counter after buying clothes and shoes worth Rs. 25,000 to 30,000 pains you a lot more!
The fact is: Changing the Payment Mechanism Influences the Spending Behavior, thereby confirming that humans do get affected by the ‘Mental Accounting Bias’.
I have seen it resulting into a damaging financial habit or a poor financial trait that one gets attached to. Our brain is wired in a way that it can hurt us financially. When it comes to investing, mental accounting can also cause people to make illogical decisions. One such example is the source of fund. Investors often spend their salary money on daily household expenses, and invest part of their salaries into safer assets like Mutual Fund Sips, Bank RD’s PPF etc. However, an unexpected bonus or a windfall gain – like winning a lottery – is more likely to be spent instantly, that too on buying a new mobile or upgrading a new car which is unnecessary at that moment, or often indulging in trading or speculative investment bets like Futures and options.
So, how can we use Mental Accounting to our advantage? Invest with a goal. Once you attach a goal to a particular investment, you mentally allocate that money to a particular purpose. It helps target a specific corpus and helps investors rationalise their spending on other social requirements. It also inculcates discipline and encourages long-term holding of investments, by which you can immensely benefit off the power of compounding!