Mental accounting is a common money mistake which even smart people commit. Understanding this mistake and avoiding this could prove to be very beneficial.
Behavioural finance experts say that mental accounting works this way: Let us say you have bought a Rs.200 ticket to a movie, but when you show up at the entrance of the theatre you realize that your ticket is lost, do you buy another ticket?
If you are 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 movie.
Now let us construct the scenario differently. Let us say you had not bought the ticket yet, and you show up at the entrance to buy your ticket. Then you realize that you have lost Rs. 200 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 now? Again, if you are like most people, you may feel upset about the lost money, but it probably would not 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 hand, 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 the 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 suffer at the high cost.
This happens because of the psychological phenomenon known as 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 at 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.
Behavioural finance experts say that mental accounting works this way: Let us say you have bought a Rs.200 ticket to a movie, but when you show up at the entrance of the theatre you realize that your ticket is lost, do you buy another ticket?
If you are 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 movie.
Now let us construct the scenario differently. Let us say you had not bought the ticket yet, and you show up at the entrance to buy your ticket. Then you realize that you have lost Rs. 200 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 now? Again, if you are like most people, you may feel upset about the lost money, but it probably would not 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 hand, 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 the 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 suffer at the high cost.
This happens because of the psychological phenomenon known as 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 at 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.
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