Thinking it through

BEHAVIOURAL FINANCE

Mental accounting can take a heavy toll on your financial planning. Here's why.

"I will not risk my money on investing in even blue chip stocks," declared Arjun Singh, advertising executive, to me a few months ago. Conservative indeed, I thought. But last week I met a completely different Singh, who proudly informed me that recently he had a windfall of Rs 50 lakh from the sale of his late uncle's property. And a lot of that money had been used to invest in guess what, Penny stocks.

Some more went on a lively vacation to Phuket and a few lakhs on horse racing. "Very unlike you Arjun," I said. "Hey, I got this money as a gift," was the quick response. Surprising how a conservative person can turn belligerent the moment he realises that this is not something he has earned.

This brings us to a very common phenomenon, namely 'Mental Accounting', a feature noticed in shows like Kaun Banega Crorepati where a participant, even after losing all the cushions like phone a friend and others, is willing to take that additional risk for higher amounts.

This is despite being completely aware that the winning amount would come down dramatically if he were to give the wrong reply. Ask the same person to take a similar bet when it comes to his own hard earned money and seldom will you find any takers.

So what is mental accounting? It refers to the mindset of treating money depending on its source. For instance, say you have been thinking of buying a Plasma TV for quite some time and you have held back on this purchase on the pretext of prudent financial planning.

But as soon as you were to get this sum through a lottery or gift, you automatically switch from 'I can't afford' to 'I can' mode.

But, you need to realise that just because you have won a lottery, received a windfall, or gift does not mean that the money does not belong to you or it has to be treated differently. Think of your money (all inflows and outflows) in terms of your balance sheet and not something that is dependent on the source.

Here are a few situations that will help you realise whether mental accounting plays a big role in your decision making:

* If you wait for a bonus or a windfall to fund any purchase when you have the requisite savings in your account

* If you are too conservative or prefer fixed interest products with your own money but would rather take a risk when you have won a lottery or received an inheritance

* If you have several lakhs lying idle in your savings account where you are earning just 3.5 per cent or fixed deposits with 9 per cent but have car loans, personal loans and credit card debt where you are paying significantly higher interest rates

It is important that you use mental accounting but use it to improve your finances. This is how you can achieve it:

Generally, people tend to believe that they need sizeable sums of money to invest and hence waste time and money creating that corpus. In the process, they find it difficult to accumulate because holding on to small sums of money is difficult as small needs keep arising.

You need to keep mental accounts of needs such as children's education or retirement and start contributing towards these goals through automatic monthly deductions from your salary or professional income.

Classify all inflows that you receive as your 'income', no matter where the inflow comes from. Remember even bonuses or gifts are a part of your wealth. And give it the same treatment as it is your money now. Do not react immediately when you receive a windfall or an unexpected bonus.

Delay gratification or making any use of this money for the next three months at least. Then evaluate your priorities or gaps in your current situation. And only after going through the exercise and making adequate arrangements for contingencies, look at spending the money on your wants and desires.

Use cash often for purchases rather than using credit cards all the time. Of course, credit cards are convenient and for several corporate executives are necessary for reimbursements, but for personal expenses make sure that you don't roll over credit from one month to the next.

Since people often tend to spend more on credit cards, if you are guilty of this practice, start paying cash for all your purchases in the future. In other words, use mental accounting to create positive cash flows. And not a financial mess.

The writer is director, My Financial Advisor