By : Harish Rao
Ever wondered why is it that when we go on a holiday, we tend to splurge on things we by and large would not have indulged in at home. For instance, spending an equivalent of Rs. 600 on a taxi ride in Singapore or Rs. 2000/- for entry into an amusement park overseas, when normally we would have thought twice about such expenses at home.
Or for that matter, willingly spend Rs. 15,000/- over and above budget while buying a house, but hesitate to spend the same amount in buying new clothes or new books.
Why is an amount of Rs. 1500/- that is received as dividend treated differently from the same amount received as a gift or as shopping vouchers received while redeeming reward points. And why is all of this different from Rs. 1500/- that is part of Salary. Its all about Mental Accounting.
Popularised by Richard Thaler, Mental Accounting is a concept that governs most of our choices and decisions in our life. As Thaler in his book Nudge highlights, "Every day, we make decisions on topics ranging from personal investments to schools for our children to the meals we eat to the causes we champion. Unfortunately, we often choose poorly".
Thaler has collaborated with other celebrated behavioural finance theorists like Daniel Kahneman and Robert Shiller.
How does it affect us in our daily life?
Mental Accounting influences the way we behave in several ways, especially when viewed against the flowing contexts.
a. Dividend Income vs Capital Gains : Why is it that certain investors prefer the dividend option, while others opt for growth (capital appreciation) option. The latter helps an investor benefit from compounding.
b. Paying by Cash vis-à-vis Credit Card : Rs. 2000 for a meal paid by cash tickles the mind much longer than a mere swipe.
c. Earned Income vs Gift Income : Mother always told us to save our ‘hard-earned money'. So what do we do with the Rs. 1000/- uncle just gifted us.
d. Context of the expense : Rs. 30 on a Kulfi after a thali costing Rs. 60 seems extravagant. However, an ice-cream for the kids costing Rs. 200 after an expansive lunch is par for the course.
e. Pain of Loss vs Joy of Gain : Most humans are more loss-averse than profit-motivated. Thus the pain of a loss is twice more hurtful than the joy of gain. Looked at from a different angle, the only time some investors assume risk, is actually to avoid a loss.
source :Wall street journal
