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Mental Money and Mental Accounting

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At one point in time or another, we have all had a ‘windfall of cash’ come into our lives. What I mean by that is you have gotten unexpected money, such as a bonus, inheritance, gift, etc. What you might not know is that how you relate to this money is different than how you relate to money you get from a pay cheque. Let’s take a closer look at ‘Mental Accounting’ and why you think like you do.

What is Mental Accounting?

Mental accounting is the equivalent of financial accounting, said Richard Thaler, an economist at the University of Chicago who was the first to describe the concept of Mental Accounting/Spending and how it works. Basically, we all have tendencies to separate accounts based on the source that the money came from and what we intend to use it for. According to Thaler’s theory, individuals assign different functions to each account and different values (i.e. Rs 1,000 from a cash gift is easily spent, compared to Rs 1,000 from a job related source). The effect is usually irrational and detrimental on purchasing decisions and other behaviours.

Here is a simple example of how people determine the importance of each account and the negative affect it can have on their bottom line. You bought a TV and the price was Rs 20,000. The amount you had planned on spending was Rs 25,000. Thrilled with saving Rs 5,000 do you a) put it in a savings/mutual fund to earn you even more or b) you celebrate your extra Rs 5,000 with a new pair of fancy name brand shoes and a nice dinner for you and your friends? According to studies you will be dancing your way to a fancy restaurant with your friends.

The Down Side of Mental Accounting

As shown in the example above, the down side of mental accounting is that you categorize items without fully thinking things through. People relate to extra savings or cash gifts as ‘free money’ and use it ‘freely’ while still carrying around credit card debt. When a billionaire was asked what he would do with a Rs 4,600,000 windfall, he said he would pay off any outstanding debt and invest the rest into savings.

I am not saying you should not/cannot treat yourself to something special or nice. Mental Accounting does not have to have a negative impact on you. If you train yourself in thinking logically about your money and treat each dollar as hard-earned money, you will soon find that your ‘free money’ is making you a lot more ‘free money’.

Re-categorizing Mental Money

cashA great way to re-categorize your thinking or re-train your brain is to start asking yourself simple questions. For example, if you are getting a  bonus, you can calculate the hours that you had to work in order to get that bonus, any overtime you had to put in, weekends worked, etc. It will get you in touch with the fact you have ‘earned’ this money, it was not just given to you. Make a spending plan for it. How much are you going to save and how much are you going to reward yourself with? Use InvestmentYogi’s Financial Planner to help you in defining your goals.

Thaler said, the alternative to having mental accounts is to ‘consciously’ ask yourself what every purchase is worth, than compare it with every other purchase.

Keeping the End Rupee in Mind

Regardless of the source of your money, keep in mind that money, is money, is money, is money. Get the picture! Money is money, regardless of the source. The value of it does not change. Being smart and sensible with ‘every’ rupee that ‘falls’ into your lap, you can steadily increase the ‘windfall’ that comes to you by investing and saving all aspects of income (gifts, lottery wins, and bonuses), which will add up to HUGE ‘winnings’ in the end.

Courtesy: InvestmentYogi

  • Mallampalli Ruthvik

    The article was good but i disagree with the Author in the Last para Saying “value of it does not change”.Value of Money always Changes due to the Concept of Time Valure of Money.

    • Yogi Cfp

      You are right Ruthvik. Money value keeps changing from time to time due to the inflation.

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