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Mental Accounting & Financial Choices

What is Mental Accounting?

Definition: The tendency for people to separate their money into separate accounts based on a variety of subjective criteria, like the source of the money and intent for each account. Coined by Richard Thaler (Nobel Prize 2017).

Rational View: Money is fungible (any Rupee is the same as any other Rupee). Behavioral View: People treat ₹1,000 found on the street differently than ₹1,000 earned from hard labor.

Key Components

Source of Money (House Money Effect)

Concept: People take more risks with "found money" or "winnings" than their "own money."

Gambling Example: "I'm playing with the house's money." Investing Example: treating dividends or tax refunds as "bonus" money to be splurged or speculated with, while salary is "serious" money.

Indian Context: A Diwali bonus is often spent on luxury items or gifts (mental account: "Bonus/Gift"), whereas the same amount in regular salary goes to savings or bills (mental account: "Income").

Allocation of Spending (Budgets)

People create rigid mental budgets:

  • Food: ₹10,000
  • Entertainment: ₹5,000
  • Fuel: ₹5,000

Irrationality: Refusing to use "Fuel" money for "Food" even if starving, or conversely, spending "Entertainment" money on unnecessary movies just to "use up the budget."

Payment Decoupling

Separating the pleasure of consumption from the pain of paying.

  • Credit Cards: Decouple pain (pay later) from pleasure (buy now) → higher spending.
  • Prepaid: Pay first, consume later (feels "free" at consumption).

Manifestations in Investing

Dividend vs. Capital Gains

The Rule: "Spend the income, don't touch the principal."

  • Investors prefer high-dividend stocks to create a "safe" spending stream, even if selling 1% of a growth stock is mathematically equivalent and tax-efficient.
  • Self-Control: It prevents them from spending down their nest egg too fast.

Losing Positions vs. Winning Positions

Integration vs. Segregation:

  • Segregate Gains: People prefer many small wins (wrapped gifts) over one big win.
  • Integrate Losses: People prefer one big loss over many small painful losses.

Sunk Cost: Keeping a mental account open for a losing stock to avoid "closing" it with a realized loss.

Behavioral Life Cycle Hypothesis

People classify wealth into three accounts with different marginal propensities to consume (MPC):

  1. Current Income (High MPC: Spend most of it)
  2. Current Assets (Medium MPC: Savings, Stocks - spend carefully)
  3. Future Income (Low MPC: Provident Fund, Retirement - don't touch!)

Nudge: To increase savings, move money from "Current Income" to "Future Income" (e.g., increased EPF contribution) before it hits the bank account.

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Key Takeaways

  • Fungibility Violated: Money is treated differently depending on source and label.
  • House Money Effect: Greater risk-taking with gains/bonuses.
  • Budgeting Rigidities: Inflexible transfer between mental categories.
  • Investing Impact: Preference for dividends, refusal to realize losses (close the account).
  • Strategy: Automate savings to move money into "Future Income" mental accounts immediately.

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