Get richer by avoiding this money mistake

Mental accounting is one such money mistake even smart people commit. Understanding this mistake and avoiding this could make you richer.

Behavioural finance experts say that mental accounting works this way: Let us say you have bought Rs 200 ticket to a movie. When you show up at the entrance of the theatre and realise you have lost your ticket, do you buy another ticket?

If you were like most people, you would probably think twice. You may still drop down the money, but you will now feel that you paid Rs 400 for Rs 200 ticket.

But let's construct the scenario differently.

Let's say you hadn't bought the ticket yet, and you show up at the entrance to buy your ticket.

And unfortunately, you realise you've lost Rs 200 in cash since you walked from the parking place.

But fortunately, you still have enough in your wallet to cover the cost of the ticket. Do you buy the ticket?

Ramalingam K, an MBA (Finance) and certified financial planner, is founder & director of Holistic Investment Planners (P) Ltd (http://holisticinvestment.in).

Again, if you are like most people, you may feel upset about the lost money, but it probably won't affect your decision to buy the ticket.

Why?

Behavioural finance experts conducted similar experiments. They found that 46 per cent of those who lost the ticket were willing to buy a replacement ticket.

On the other side 88 per cent of those who lost an equivalent amount of cash were willing to buy a ticket.

Both scenarios are a loss of Rs 200. However, in the second scenario you separate the loss of Rs 200 from the purchasing of the ticket.

In the first you consider the cost of the movie as a total of Rs 400 and baulk at the high cost.

It is because of the psychological phenomenon known as mental accounting.

Click NEXT to read what is mental accounting...

One of the fundamental concepts in economics says that wealth in general and money in particular, should be fungible.

Fungibility, in a nutshell, means that Rs 100 in lottery winning, Rs 100 in salary and Rs 100 tax refund should have the same significance and value to you since each Rs 100 has the same purchasing power in the market.

But do you treat them in a similar way?

Mental accounting has enormous consequences in your daily life. It affects how you spend money and how you save. It influences how you deal with losses and windfall gains.

How does mental accounting affect you?

• The source of the money affects how it is spent
• You tend to dine lavishly with the 'gift meal vouchers' given by your company. But you will be dining consciously if you were paying out of your salary
• You are most likely to spend more with credit cards than with cash
• You may consider tax refund as 'free money'. In actual terms it is your own money. You will not spend tax refunds, birthday gift money or lottery winnings on essential things like utility bills, school fees, paying off your credit card debt. But you will be more than happy to spend the same money on discretionary items such as vacations or a trendy mobile phone

Don't be a victim of 'relative cost'

Assume you are going to a super market to buy a laptop. The price is Rs 40,000. But you get to know that there is another branch of the supermarket, ten-minute walk away, in which the same laptop is sold for Rs 39,950.

Will you walk down to the other branch to save Rs 50?

Let us say instead of buying a laptop you have planned to buy a memory card. The price at the supermarket is Rs 100 and at the other branch the price is Rs 50.

Where will you buy the card?

Most of us will make a trip to the other branch for the memory card but not for the laptop. Because we think that the Rs 50 saved on Rs 100 item is better than the same amount saved on an item worth Rs 40,000.

But in both cases the situation is same. You save Rs 50 by making 10 minutes walk to the other branch.

Remember that money is money.

Rs 50 saved on Rs 40,000 laptop is not less money than Rs 50 saved on Rs 100 memory card.

How to face mental accounting and spend consciously?

• You can use mental accounting to your advantage by spending money out of your salary. Immediately invest the 'free money' like tax refunds, gifted money or any other windfall gains
• Imagine that all income is earned income
• Use the free meal vouchers and other gift vouchers to buy essential items
• Pretend you don't have a credit card. I am not telling you not to use credit cards. I am saying you should stop and think: would I buy this if I were using cash?

A successful practical strategy

You can have two bank accounts. One for the purpose of savings and the other one for spending.

Every month you need to set aside some amount for expenses as per your budget or previous experience. That amount you need to transfer to your spending account.

Keep the balance amount in your savings account.

You need to meet all your expenses including your credit card payment from the spending account. You should not spend from your savings account.

In between, if you receive any cash gifts or windfall gains, deposit them in your savings account.

If you receive gift vouchers, then transfer the money equivalent of that voucher from your spending account to your saving account.

This will help you not to exceed your spending limit when you receive the gift voucher. As a result you will not use it lavishly and use it only on pre-planned things.

When it comes to money your mind unconsciously plays this trick of mental accounting. You have understood that today. So hereafter, you can avoid this mistake and you become richer day by day.