How to use Mental Accounting to your advantage

Recently we witnessed a Kaun Banega Crorepati (KBC) episode where the participant who had won 1 crore went for the 5-crore question. He had a lifeline and had already become a crorepati, yet decided to go for the kill. Sadly, he got the answer wrong and went home with just 3.2 lakh. It is disappointing to see a person who made 1 crore losing it the next moment because of the decision that he took. Not just this gentleman, there are many others on the show who fell prey to the phenomenon of ‘mental accounting’.

Mental accounting is nothing but the way we decide to treat money differently because of its source.    Mental accounting can be good sometimes when we earmark a certain portion of our income towards savings or create a savings budget; but more often than not, it leads to self-destructive financial habits or poor financial decisions. According to traditional textbook theory of economics and finance, mental accounting should not exist as money is fungible, which means that a rupee in hand will have the same value and utility as that in a bank account. However, real life is different and our mind creates different mental buckets, where it’s difficult to pay off a loan with the money one plans to buy an LCD. Thus, mental accounting is a powerful phenomenon and must be worked to one’s advantage to gain from it and avoid costly mistakes. Here is how to do it.

Train your mind to believe that all money is equal and you will not treat money differently depending on its source. As soon as you receive money from a bonus or a windfall, do not make any financial decisions. Let two or three days pass and let the euphoria settle a little. Take stock of your overall balance sheet and think about your important financial needs. Once you have understood your requirements, do the numbers and take a decision. If you have the itch to spend, gamble or do anything else with that money, set aside 50% of it as savings and spend the rest.

Investors can use mental accounting to their advantage by deciding to set a savings budget every month, creating a goal-oriented asset allocation and reviewing it regularly like a semi-annual ritual.

Source : ET