Mental accounting makes you spend more!!!

Some time back a friend of mine had received this great stock tip. The broker told him about a particular stock, which was sure to go up. Taking the broker's word, my friend bought the stock.

When he bought the stock, the stock was priced at Rs 4. He bought 5,000 stocks for Rs 20,000. The broker's tip turned out to be right and the stock within three month's time had touched Rs 10. The Rs 20,000 that my friend had invested had grown to Rs 50,000. A return of 150% in just three months.

My friend did not sell out at that point in time, hoping that the stock will keep going up. But then one day the price started falling and it just kept falling. "If I sell out now, and it goes up again, I will look so stupid," he told me.

The stock did not give an opportunity to my friend to look stupid and kept falling, and finally touched Rs 4, the price at which he had bought the stock. At that price, he sold out.

"You know I didn't lose anything on that bet. I bought the stock for Rs 4 and I was able to sell it for Rs 4," he told me.

But was this really the case? If my friend had sold out at any price greater than Rs 4, he would have made some money. But he chose not to.

He was a victim of what behavioural economists, call mental accounting. Richard Thaller, the behavioural economist who coined the term, mental accounting, defines it as "the inclination to categorise and treat money differently depending on where it comes from, where it is kept and how it is spent."

Given this, gamblers who gamble and lose their winnings and manage to recover the initial money they had put to play, feel they haven't lost anything.

Same is the case with investors like my friend. But the fact of the matter is that gamblers or investors like my friend would clearly be richer if they had stopped gambling earlier or sold out of their investment earlier.

Gary Belsky and Thomas Gilovich point out in their book Why Smart People Make Big Money Mistakes and How to Correct Them, "By assigning relative values to different moneys that in absolute terms have the same buying power, you run the risk of being too quick to spend, too slow to save, or too conservative when you invest - all of which can cost you money."

Clearly there are many other consequences of mental accounting when it comes to money.

Since we categorise money into different mental accounts, the general tendency is to spend the money one receives unexpectedly (gift, bonus, et cetera) far faster than the salary that one gets every month.

As Belsky and Gilovich point out: "Consider tax refunds, for example. Many people categorise such payments from the government as found money -- and spend it accordingly -- even though a refund is nothing more than a deferred payment of salary. Forced savings, if you will. If, one the other hand, those same people had taken that money out of their paycheck during the course of the previous year and deposited it into a bank account or a money market mutual fund, they would most likely think long and hard before spending it on a new suit or Jacuzzi."

Now you know why you ended up spending the entire bonus you received for working so hard last year, so quickly.

Mental accounting is also responsible for all the money you spend using credit and debit cards.

As Belsky and Gilovich point out: "In fact, credit cards and other types of revolving loans are almost, by definition, mental accounts, and dangerous ones at that. Credit card dollars are cheapened because there is seemingly no loss at the moment of the purchase, at least on a visceral level. Think of it this way: If you have $100 cash in your pocket and you pay $50 for a toaster, you experience the purchase as cutting your pocket money in half. If you charge that toaster though, you don't experience the same loss of buying power that your wallet of $50 brings."
 
Back
Top