Before knowing whether you are a victim or not, we will first see what mental accounting is. Mental accounting is a part of Behavioral Finance, which says, individuals assign different levels of utility to each asset group, which affects their consumption decisions and other behaviors.
The concept of Mental Accounting
With the definition above, it is difficult to understand what mental accounting is, so we will see an example to understand it better. Most of us are using mobile phones and also rate cutters. For example, if you recharge for say Rs.27, 100 SMS will be free for 21 days. In this case, if we pay Rs. 27 initially where is the concept of free here? But what we feel is, if we pay Rs.27, they are not deducting any amount from our main balance whenever I send an SMS within those 21 days.
Here is the Second one..
Let me give you another example, you are in a shop to buy a 32 LCD TV which costs Rs.32000. You know another shop 10 min walk from this shop, which is also selling the same brand LCD TV with same specifications but Rs. 50 less. Will you walk to that shop?
You are planning to buy a Pen drive which costs Rs. 300 (instead of LCD TV in the case above). Now you know another shop 10 min walk from this shop, which is also selling the same model Pen drive for Rs. 50 less. Will you walk to that shop?
Most of us are ready to walk to the next shop in the 2nd case which is not so in the 1st case, even though you are saving same amount i.e., Rs. 50 in both the case. Why?
Because, in the first case, Rs.50 is given less value when compared to the amount involved i.e., Rs. 32000. In the 2nd case, Rs. 50 is given more value when compared to the small amount Rs. 300. But the amount is same Rs. 50.
Dont be a victim
Mental accounting should be understood and used effectively to achieve your financial goals sooner. For example, you are saving certain amount of money every month to achieve a goal. Year on year you will receive bonus, tax returns and so on. You feel those amounts as extra money and start spending it by going to a star hotel or going for a trip to the tourist spot etc., We should understand that, Bonus is part of our salary. Tax returns are the amount we have paid in excess to the IT department. If you think this way, we will spend it wisely by investing that amount to reach that goal sooner.
This year Aug 5th is the last date for filling tax returns and if you have any returns, the IT department will credit that amount to your account. So remember that it is not extra money! It is the amount which you have paid in excess to IT department and use it wisely.
The author is Arul Prakash B, a PGDM in Finance was an Independent Financial Planner and Director of Pushpak Financial Planners (http://pushpakfinancialplanners.weebly.com). Investment Planning, Risk Management, Portfolio Management, Tax Planning are his area of interest. He has passion for Personal Financial Planning. He can be reached at pushpakfinancialplanners@gmail.com