Mental accounting is the tendency to allot money into separate categories based on different criteria such as the source of money, whether it was earned or gifted to them, the purpose for which the money was saved.
The movie ticket conundrum is a classic example of mental accounting.
Imagine you decide to watch a movie and the ticket cost is Rs. 200:
Case 1: You have already purchased the ticket of Rs. 200 but lose it along the way.
Case 2: You lose Rs. 200, which you were going to use for buying the ticket.
The outcome of both these scenarios is that you have to shell out an additional Rs. 200 to buy a ticket.
However, people were more likely to spend Rs. 200 again in case 2 rather than case 1. When the additional outflow will be Rs. 200 in both the cases why are people more likely to spend Rs. 200 on loss of cash than ticket? The answer lies in our tendency to allocate the Rs. 200 ticket to a ‘movie ticket account’ in our mind. Now an additional outflow of Rs. 200 brings the total of the movie ticket account to Rs. 400, which may seem expensive. Meanwhile loss of cash is assumed to be loss of money in hand. The money spend on movie still feels to be Rs. 200.
Mental accounting makes us spend cash received as gift during festivals or bonus more freely compared to our monthly wages. As the money received was unaccounted for in our budget, we tend to treat it as a windfall and are more prone to splurge it. While it may seem illogical to decide the use of money based on its source, we see this happening often.
Another example is of a person spending lottery winnings on luxury items rather than using it to pay-off existing debt. So, instead of reducing their debt burden which is a financially prudent choice, the person ends up sticking to his original debt repayment plan.
People tend to divide their total portfolios in two buckets, namely ‘money they can afford to lose’ and ‘money that they cannot afford to lose’. While this may seem a financially wise approach, it may prompt the investor to take undue risk on his ‘can afford to lose’ portfolio, which may decrease his overall wealth.
How can you help your clients overcome mental accounting bias?
Help them understand that the value of the rupee does not change based on the source. Money received be it from wages or as a gift or tax refund, needs to be spent carefully irrespective of whether it is earned or received. They should avoid dividing money into various accounts based on source.
Use it to their advantage
Mental accounting becomes particularly useful in goal planning. Say, your client has allocated a particular corpus for their son’s education and they have cash requirement; in such a situation, they will try to explore all available options before even thinking of withdrawing money from the education kitty. Thus by assigning client’s portfolio to various goals you can help him save better.
Help them understand that money is fungible (interchangeable)
This is tricky because in a sense it contradicts our earlier point. While it may be irresponsible to withdraw retirement money to fund unnecessary extravagant purchases sometimes it is necessary. Say your client needs money for an emergency then it is better to withdraw retirement money saved in a FD (which earns 8%) rather than taking a personal loan (which costs 12%).
Do these scenarios sound familiar? Tell us how you helped your clients avoid mental accounting bias.