What is Mental Accounting Bias?
Created on 13 Aug 2022
Wraps up in 6 Min
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Updated on 10 Sep 2022
Do you remember Sushil Kumar from Kaun Banega Crorepati, the one who actually won 5 crores? He was poor before he won 5 crores. He is poor (actually, bankrupt) after he had 5 crores.
According to standard economic theory, the worth of $100 should be the same regardless of how it was acquired. Nevertheless, behavioural finance theory contends that this is not the case.
According to behavioural finance, individuals place varying values on the same quantity of money based on how it was obtained. This notion was established by psychologist Richard Thaler and is known as mental accounting. This article examines Mental Accounting Bias and its influence on investment behaviour.
What is Mental Accounting?
Richard Thaler first presented the notion of mental accounting in a Journal of Behavioral Decision-Making article titled "Mental Accounting Matters." Thaler observed that people's perceptions of money's worth lead them to make illogical decisions. The notion asserts, in basic terms, that individuals define money differently based on subjective criteria, and it frequently leads to irrational spending and investing decisions.
The idea indicates that individuals do not view money as fungible – that is, replaceable – and instead attach their spending to particular budgets. For instance, if an individual receives a ₹100,000 end-of-year bonus for excellent performance, they may feel entitled to spend the money on luxury goods, such as restaurants, extravagant trips, and other luxuries that they would never justify spending regular income on.
The notion posits that people are more inclined to act impulsively with unexpected money since it was not incorporated into their financial strategy.
Investing Requires Mental Accounting
Individuals may fail to examine the dangers or correlations of mental accounts if they place each objective and the money intended for each goal in a distinct mental account. Instead of perceiving the portfolios as a single entity, it may build portfolios that resemble a stacked pyramid.
Thaler stressed fungibility in his critique of the notion of mental accounting. The notion claims that all money is interchangeable and that people should treat all money equally, regardless of its intended function or origin.
Thaler noticed that people frequently disregarded the fungibility principle in situations involving windfalls like bonuses, tax refunds, lottery winners, and birthday money. It indicates that "gift money" is not part of the individual's regular salary and is being spent on unjustifiable extravagances. Therefore, he recommended that individuals handle all money equally and spend windfalls in the same manner as their regular income, based on a sound financial strategy.
Here are some of the benefits of mental accounting:
It can facilitate the achievement of investment-related objectives. When a set amount of money is invested in a retirement account, that money cannot be withdrawn for spending purposes. In this manner, people may avoid wasteful expenses and save the same amount of money for the future.
It aids in the identification and categorization of individual objectives. It allows merchants, marketers, and people to prioritize each strategy.
It can check and evaluate the success of its assets periodically.
It aids marketers in establishing a strong rapport with their customers.
The following are the drawbacks of mental accounting:
It causes people to treat money obtained from various sources differently. People may feel compelled to squander inherited funds more quickly.
It encourages folks to spend their money on worthless items and activities.
It permits individuals to maintain excessive cash as an emergency fund rather than investing it or utilizing it to settle high-interest obligations.
It leads to financial inflexibility since individuals are unable to fulfill their objectives and modify their budgets depending on current financial data.
Mental Accounting Bias Examples
Examples of Mental Accounting Bias include the following:
A tax refund is a compensation for any taxpayer's excess tax to the federal or state government. If a taxpayer receives a tax refund, it indicates that they paid excess taxes during the previous financial year, which constitutes an interest-free loan to the government.
Most taxpayers view tax refunds as a bonus or windfall that has little bearing on their annual budget. It is incorrect since tax refunds reflect money belonging to the taxpayer, and the tax authorities only recover an amount equal to the paid tax. Instead, tax refunds should be regarded as regular income, regardless of origin.
A bonus is a payment received in addition to a person's regular salary. Typically, entry-level and senior-level personnel are rewarded with bonuses as an incentive. Additionally, corporations employ incentives to recognize exceptional accomplishments or the attainment of certain milestones.
Employees view bonuses in a different way than ordinary remuneration. As a result, many employees spend their bonuses on needless items such as vehicles, trips, expensive apparel, etc.
Such expenditure goes against the fungibility principle. Before spending bonuses on excessive purchases, employees should consider what the money may be spent on instead — something more deserving of that money.
Wins in the Lottery
Lottery winners sometimes squander their wealth on questionable goods only rationalized by the undeserved windfall they receive. As a result, many lottery winners become bankrupt immediately after obtaining their reward and spending it on unnecessary things.
If the wealth had been spent on the winners' pre-win financial plan, they would have earned returns on their assets or incurred acceptable expenditures.
How Might Mental Accounting Affect Investment?
Investors with a stated budget allocate a set percentage of their revenues to investments. A documented budget with a specific dollar amount raises the pressure to make these commitments because a mental investment account must be closed by paying money. However, if an investor does not set aside money for investments and instead invest the remainder, they tend to invest less.
If a person reinvests their profits, their risk tolerance improves significantly. For example, if a person spends ₹10,000 of their hard-earned money, they will be exceedingly careful. However, if that ₹10,000 has been transformed into ₹20,000 through capital gains, the investor would undoubtedly take unnecessary risks with the capital gains. People do not mind taking excessive risks with capital gains because they perceive them to be free money.
The spreads at which day traders join and exit equities are often slim. Frequently, once transaction fees and taxes are accounted for, they barely recoup the cost of their capital. Because the funds are designated for dangerous day trading investments, they do not mind paying the exorbitantly high expenses connected with such trading.
People become very cautious after receiving lump sums of money. People who get a large amount of money are prone to invest in secure, low-yield choices. However, those who get the same amount in monthly payments are more inclined to favour high-yielding equities investments. It would be appropriate to divide the funds across the two investments. However, due to Mental Accounting Bias coming from mental accounting, it isn't easy to do the same.
The Bottom Line
Our mental accounting processes drive us to make poor financial judgments for various reasons. All of these causes stem from the fact that individuals do not consider the value in absolute terms. Instead, the value of an object is relative to several other variables.
When investors choose assets for their risky and safe portfolios, Mental Accounting Bias is also present. Investors separate their safe portfolios from their speculative ones to protect the former from the detrimental effects of the latter. Investing in speculative and risky businesses suggests that investors have more money to lose and are willing to take a risk.
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