Just got your big bonus? You might fall prey to Mental Accounting
Amar is a CFA Charterholder and CFP, having over 20 years of experience in IT and Financial Services. He is very passionate about spreading financial literacy and has authored four bestselling books on Personal Finance.
23 Oct, 2017
A couple of months ago, I met a man by the name of Mr. Arjun Seth, who worked as a corporate executive. After having spoken for a while, he confided in me that he would never in his life, waste his money on making investments, even in blue chip stocks. I thought to myself that he must definitely be a conservative investor.
Cut to a few weeks later when I met Arjun, he very enthusiastically informed me that he had recently experienced a windfall of Rs. 50 Lakh from the sale of a late uncle’s property. However, most of that amount had already dwindled down, courtesy of investments in penny stocks, on an exciting holiday to the Maldives and rather surprisingly, on horse race betting. When I commented on the unlikeliness of this occurring the last time I met him, Arjun responded by joyfully saying, “Hey, I got the money as a gift.”
Isn’t it surprising how a conservative person turned belligerent?
It actually isn’t all that surprising, considering how common the phenomenon of ‘Mental Accounting’ actually is. Seen very often on TV shows like Kaun Banega Crorepati, Mental Accounting takes place when, even after losing out on all of their lifelines, the contestant is willing to take risks for higher amounts. This despite knowing and understanding that the winning amount could reduce drastically if the wrong answer is given. If the same person was asked to make a similar sort of bet with their own hard-earned money, you would find yourself without a taker. In fact, if you’d ask almost any other person, pretty much everyone would turn down your bet.
So, what then is Mental Accounting? It refers to the mindset of treating money depending on its source. For example, say you have been thinking about buying a new LED TV but have been holding off because you’re looking to make prudent financial decisions. But, the second you get the money required to buy the TV as a gift or through a lottery, there is a shift in attitude from “I can’t” to “I can”.
In this sort of a situation, what the individual needs to realise is that just because they’ve won a lottery, received a gift or windfall, it doesn’t mean that the money doesn’t belong to them or that it should be treated differently. The ideal thing would be to think of all your money, inflows and outflows, as a balance sheet and not something that is dependent on the source.
There are some situations that commonly occur when people apply Mental Accounting while making their big money decisions.
- If you wait for a bonus or a windfall to make a purchase, when you already have the requisite savings in your bank account.
- If you are too conservative or prefer fixed interest products with your own money but would rather take a risk when you have won a lottery or received an inheritance.
- If you have a substantial amount lying in your Bank Account or Fixed Deposits, but you have car loans, personal loans and credit card debt where you are paying significantly higher interest rates.
Making use of Mental Accounting isn’t bad but its dividends pay off only when it is used to improve one’s finances. Here’s how you can do it.
- Generally, people think they need sizeable sums of money to make investments and so they waste time and resources in creating the corpus. In the process, they find it difficult to accumulate money because holding onto small sums of money is difficult as needs keep arising from time to time. There needs to be constant Mental Accounting done, of children’s educational and one’s own retirement, etc. Post this, a decision to begin contributing towards these goals through automatic monthly deductions from one’s salary or personal income must be taken.
- Regardless of where you have the inflow of cash from, classify it as your ‘income’.
- Understand that even bonuses and gifts are a part of your wealth. This will help you accept it as your own money and treat it as you would treat your own.
- Don’t make hasty decisions when there is an unexpected inflow of wealth. Delay gratification.
- Evaluate your priorities or the gaps in your current situation. It is only once this is done and enough money has been set aside for contingencies, should you look to spend the money on other wants and desires.
- Avoid making purchases with a credit card. Credit cards might definitely be convenient and for a lot of corporate executives, necessary to make reimbursements. But for personal reasons, it is imperative to ensure that the credit doesn’t roll from one moth to the next.
Essentially, the idea is to make use of Mental Accounting to create positive cash flows. And not a financial mess.