Tuesday, January 18, 2011

Mental Accounting

Suppose you are going to a movie and as you enter the cinema, you discover that you have lost your movie ticket you’ve just paid RM10 for. Would you spend another RM10 to get a new one? If you are like most people, you would probably think twice because you will feel that you will end up paying RM20 for a movie actually worth RM10!

Now let’s construct the scenario differently. You are going to see a movie. On your way to the movie theatre you drop a RM10 note on the bus. You are disappointed, of course, but would this affect your decision to buy the movie ticket? You will probably say to yourself: “Damn it! That’s my luck!” Arriving at the cinema, you will forget about the incident and stand in line to get a movie ticket.

In fact, the above research was conducted by some psychologists who discovered that only 46 percent of those who lost a ticket were willing to buy a replacement ticket, whereas 88 percent of those who lost an equivalent amount of cash were willing to buy a ticket. Since the lost ticket and the lost cash had the same value, their loss should have been experienced in the same way, but why were there twice as many people willing to ignore the lost cash but not the lost ticket? Why is it that you feel more pain in losing the movie ticket than the ten-dollar note?

This is due to a psychological phenomenon proposed by the famous psychologist, Richard Thaler, known as mental accounting. It says that people tend to separate and categorise income and expenses into different accounts in their heads. For example, you might have an entertainment fund, an investment fund, an education fund for children and so on.

Losing a movie ticket and having to buy a second one takes RM20 out of your entertainment fund when you planned to take only RM10, so it’s “out of my budget”!

Many of us commit this mental mistake in our daily lives without realising it. For example, we treat the company bonuses, capital gains from selling stocks, dividends and tax refunds as a “windfall” source other than our normal source of income. We splurge on luxury items such as LV bags, Caribbean Cruise and Rolex watches with this “windfall” money in spite of having a housing loan and a car loan due for payments.

Somehow we have grouped our income and expenditure into separate mental “funds” or “budgets” that are not easily combined. Money received as part of our salary is treated differently from money received as a bonus. Similarly, money spent to buy a fixed asset is viewed differently from the same amount of money spent to treat ourselves to a dinner at a luxury restaurant.

From an economic perspective, these mental accounting rules violate the economic principle of “fungibility”, which means that all money is equal. A dollar is still a dollar whether you get it as a gift from a friend or from your salary. Hence, when the principle of fungibility is violated, people act in economically irrational ways.

Stock investors often apply mental accounting when making investment decisions. We have the tendency to treat capital gains as windfall money and indulge in luxury goods with the profits. Imagine how much money we can accumulate if we simply reinvest the money into various forms of investment and let our money grow for us.

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