Mental Accounting: Let’s Sketch It Out for a Better Investment Approach
Before we start shedding lights on the topic, let’s make one thing clear that the term “mental account” does not depicts any unfit accounting condition. Rather, it’s a part of our daily life and we all do it regularly. But the fact is that least of us know about it.
So, today we are going to paint a clear picture of mental accounting to let you understand it better.
Put yourself in a situation that you are planning to go to a show tonight. The ticket for the show costs Rs. 500, and you’ve already purchased it the day before. You are excited and all set to go to the show. But, when you arrive there, you realise that you forgot to bring the ticket which you left at home on the table. Now, you don’t have enough time to go back to home and get it. What will you do? Will you purchase another Rs. 500 ticket at the door?
Now envisage an another situation that you are planning to go to a show tonight. The ticket for the show costs Rs. 500, and this time you decided to purchase the same at the door. Earlier this afternoon, when you went to a shop for buying some snacks, you realised that your wallet that contained Rs. 500, has been missing. What will be your call now for the show? Will you still go to the show tonight and buy the ticket at the door for Rs. 500?
What Should be the Right Decision and Why?
In the first situation, most of the people will not purchase the another ticket at the door because the feeling that the cost of first ticket which they unfortunately left at home will be a waste, will not allow them to do so. Purchasing the second ticket at the door will feel like they are paying Rs. 1,000 to attend the show instead of Rs. 500.
However, in the second situation, many people will buy the ticket at the door and attend the show, instead of the fact that they already had lose Rs. 500 which were stolen this afternoon. Just because the fact is unrelated to the event, it doesn’t impact the decision of most of the people to attend the show.
Realise It Yourself:
Even if you would buy the ticket in both the situations, it feels different. Many of us will definitely hesitate and may not buy the ticket in the first situation as it stings a bit more than buying the same in the second situation. However, both the situations are mathematically identical. If you enjoy the show, you are out of Rs. 1,000, and if you don’t, you are out of Rs. 500. Financially, there’s no difference because in both the situations you are either at loss of Rs. 500 or Rs. 1000. So, why does it feel different? Why is it harder to spend Rs. 500 in the first situation? Why do we think this way?
The Answer Is ‘Mental Accounting.’
Mental accounting is an act of mind which helps people to separate accounts based on different subjective criteria such as the source of money, and the intent to spend it.
Removing the Dust from the Concept:
We keep our money in different types of physical accounts such as a saving account, fixed deposits, current accounts, retirement savings, education savings, etc. But, sometimes we simply keep all these accounts purely in our mind. It means, in spite of making any physical deposits for different purposes, and splitting the money into different accounts, we keep the record in our mind for these various purposes. This is called mental accounting.
How Does it Impact in the Above Two Situations?
In both the situations as mentioned above, we have different mindset. Thus, the feelings at the time of spending Rs. 500 at the door in both the situations are different. In the first situation, the Rs. 500 spent for the ticket that you purchase the day before has already been associated with the mental account. Your mind has recorded it that you already have spend the bucks for purchasing the ticket. Now, purchasing the same again seems repeated to your mind. Thus, when you are at the door and thinking to buy the ticket again, you get the feeling that you are wasting your money. You’ll feel that you are spending Rs. 1,000 to attend the show.
But, in the second situation, the money that you lost is not in the same mental account in which the cost of attending the show is. Therefore, spending Rs. 500 at the door, in the second situation, doesn’t make you feel that you are wasting it. Instead, you feel like spending only Rs. 500 to attend the show.
However, all what you are spending is coming from the same physical account, i.e., your savings account. You will still get different feelings in different times and situations of spending.
Still Not Convinced? Let’s Try Another One
Suppose that you are looking to purchase a new calculator, and a laptop. You went to a store that sells calculator, the price is Rs. 390. Before buying that piece, you found out that there is another store which is about twenty minute walk, and is selling the same calculator for Rs. 190. Would you go there?
Similarly, assume that you are at a store that sells laptop you want, and the price is Rs. 35,260. Before buying it, you find that the other store which is also about twenty minute walk is selling the exact same laptop for 35,060. Would you go there?
In both the cases as mentioned above, you can save Rs. 200 each. But still if you ask the same situation to the mass, most of the people will deny going to the other shop in case of the laptop. But, they will definitely grab the opportunity to buy the calculator at a discount of Rs. 200. This is again a case of mental accounting bias.
In case of the calculator, the price is Rs. 390 and you are getting the option to buy the same at Rs. 190, i.e., almost 48.7% discount means half of the price. So, you will definitely think to buy the calculator from the other store which is about 20 minute walk from the first one. But, in the case of buying laptop, the majority of the people will tend to ignore the second option because they know that saving Rs. 200 on the purchase of Rs. 35,260, i.e., a discount of around 0.56% makes no big difference. Thus, the investors generally feels achievement in the first scenario and waste of time in the second case. Saving Rs. 200 in case of calculator is almost 50% savings. But the same amount in case of laptop means a savings of 0.56% which seem irrelevant.
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