Mental Accounting

If you went to watch a movie and lost the ticket would you buy a new ticket? But if you lost a currency note of INR 500, would u not buy a movie ticket using your debit card? After I came across this Question, I asked almost everyone I met for the next few days to understand if the response of people is the same and what do they think before taking a decision. Most people said that they would not buy a second ticket if they lost the first one, but would borrow/use their debit card to buy the ticket if they lost the INR 500 note kept aside for the ticket. The incidents are basically same; you lose INR 500 on the lost movie ticket or the INR 500 note, the amount lost is the same. The only difference is the way you lose the money but you tend to combine two financial outcomes depending on the perceived benefits from these two outcomes. How does it impact us? Our mind segregates money into different accounts based on the situation we have derived the money from or spent in. Our mind is making different folders to categorize and treat money differently, depending on where it comes from, where it is kept and how it is spent. This process makes us treat money earned through different sources differently, thus, increasing our spending habits. Let me explain this with more relatable examples. In my article on cashback offer is a trap, I had discussed how cash back makes us spend more on things we do not need so that we can utilize the cash back. The reason why we do that is in our minds; we create a separate folder for cash back received and are ok to spend that because we do not treat it as our own money. Whereas, in the case of a direct discount, we just spend less in the first place thus leading to genuine savings. In another article of Insurance frauds, I have discussed how I got duped into buying the wrong insurance product and had to surrender the same after 2 years. I had paid a premium of INR. 120,000 for that insurance but received only INR. 58,000 on surrendering my insurance policy. This money should have gone directly into my investment account as it was already invested money and only then the surrender would have made sense. However, I treated it as a windfall money and ended up spending most of it for shopping, buying a new phone and taking an impromptu trip to Goa. There are many times I have personally lost investment opportunities or incorrectly utilized the money received due to this mental accounting. Some more examples could be treating your bonus income, income-tax refunds, buy-back offers, health insurance claim received (post hospitalization) etc differently than your regular source of income.
                                                                                     Creating mind folders of the money coming in based on its source leads to increased spending.
Leads to slower growth in wealth Mental Accounting is the reason why people continue to earn low-interest rates on fixed deposits in the bank while paying a high rate of interest on their credit card debt or a personal loan, instead of breaking the fixed deposit and repaying the debt. Remember that the interest you earn on your fixed deposit will always be lower than the interest you pay on your credit card debt. We have also discussed how credit cards overspending are an act of mental accounting and how it impacts our spending behavior. We consider the credit card limits or the money used via credit card as different money and buy anything and everything through that without understanding that it is. Refer article Why you must avoid credit cards. How to deal with it Understand that money is fungible. All the money coming in (irrespective of the bank account and source) should be your income and the money going out - your expense. This simple 2-way categorisation can help one deal with their overspending, debt problem and earn higher interest rates through right investments. This is why it is very important to develop the right attitude of managing finance along with the technical skill to understand the various financial products.
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