Technical Analysis

Mental accounting in investment decisions

ADARSH GOPALAKRISHNAN | Updated on November 15, 2017

Mental Accounting leads you to take decisions that may intuitively feel safe or even affordable but can cost you real money

Is all money the same? Two ten rupee notes are identical in what they can buy.

Yet when it comes to spending or saving, how people label money has a huge impact on the way it is used. This is explained by the mental accounting bias. Recognising this bias is useful in enforcing discipline when it comes to saving.

The classical idea was that all money regardless of how much or where it comes from be it a salary, tax refund, bonus would be viewed the same.

It would also be employed towards a purpose which was the individual's highest priority (utility in eco-speak). But Economist Richard Thaler pointed out that humans in the course of everyday life behaved quite differently.

Drazen Prelec and Duncan Simester, two marketing professors, conducted an experiment where the made individuals bid for tickets to a basketball game. Half the group were told to pay by cash and the other half by credit card.

The results showed that people using credit cards consistently put higher bids on the ticket than those bidding with cash.

Do the results come as a surprise to plastic-lovers out there? Similar trends have been noted with individual behaviour with regards to their retirement funds, funds stocked away for educating their children, tax-refund cheques, bonuses and pretty much any unexpected source of income!

Let's say you decide to set aside 20 per cent of your salary every month towards your retirement.

Now you decide this is the portion of your funds you don't dare touch for everyday spending or even the occasional big treat.

The portion acquires a ‘holier than the rest of your money' halo. Conventional wisdom also dictates that you don't dare risk this portion by buying volatile assets like stocks! Instead you stash the entire money into a recurring deposit or a ‘safe' product.

Mental Accounting leads you to take decisions that may intuitively feel safe or even affordable but can cost you real money. In the above example, your long-term savings could greatly benefit from exposure to stocks over a period of several years. But labelling it as ‘safe' or ‘for the future' keeps you from taking sensible risks.

Another everyday scenario, you walk into a shop to buy a laptop. There is a sale on, with progressively better models having bigger discounts. You went into the shop wanting to spend Rs 30,000. The model you eyed is selling for Rs 25,000 but a even bigger fancier one which you may have little use for is selling for Rs 35,000 as opposed to the Rs 4,5000 it usually sells for. You decide ‘Wow, that's a great deal! I am going for the bigger, better one.' You flash your card (you brought only Rs 30,000 in cash) and instead of saving Rs 5,000, you've spent Rs 5,000 more on a piece of technology you're never going to fully tap into. Net effect you've lost Rs 10,000.

Quick fix

While the discipline to put away a portion for your family, your future or even for a once a year holiday or ‘treat' will let you enjoy yourself without compromising your future, nuanced investment approach helps. If you can keep away from hyperactive portfolio checking and constantly buying and selling, stocks really can pay off for you over ten or twenty years. So don't let labels keep you from making money.

A bonus or refund cheque is money you've earned. It's not a gift from the gods. Treat it as you would your salary and make sure it fits in with your grand savings or spending scheme. A credit card needs to be paid. It is not a gift from a rich uncle. In fact it's from an uncle who can really fleece you if you spend more than you make. So before you swipe, check your account balance, and think of how it will hurt that holiday you've always wanted for years.

Published on April 07, 2012

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