All money is not perceived in the same way by your mind.
Don’t believe me? Maybe the narration of a few incidents will warm you up to this proposition. My aim is to reveal to you that your perception of money will differ depending on its source and the ease at which it came into your possession.
#1. Money is treated differently, depending on the source.
A couple went on a fishing trip and caught some salmon. They packed the fish and sent it home on an airline, but the package was lost in transit. They received $300 from the airline, out of which they splurged $225 on a dinner. They had never spent that much at a restaurant before.
Money is not supposed to have labels attached to it. Yet the couple behaved the way they did because in their mind, the $300 was a "windfall gain". The extravagant dinner would not have occurred had each received an increment of $150.
This story by economist Richard Thaler is used to describe mental accounting. It is a concept that has many implications, one of them being that money is dealt with differently depending on its source.
Psychologist Hal Arkes narrated a story of employees of a firm taken to the Bahamas on a retreat and each given a cash bonus of $100. Almost all of them headed to the casino. What was interesting was that up to $100, they had no qualms betting. The moment it crossed that threshold, they got more cautious and slowed down or stopped altogether because they felt they were playing with their “own” money rather than the “free” money. Ironical is it not? The $100 was their “own” money too, it is just that it was handed to them and never came out of their own pocket.
The truth: There is no “free money” or “easy money”. All money should work towards improving your finances.
#2. Money is treated differently, depending on what it is called.
In the book Why Smart People Make Big Money Mistakes & How to Correct Them, the authors talk about an experiment conducted with 24 students at Harvard University.
The students received $25 each as part of a research project and could spend as much as they wanted at a particular store. The unspent amount (from $25) would be sent to them by cheque.
All were told that the research was partially funded by tuition dollars, but half of them were told that it was a bonus, while the other half was told that it was a rebate. That apparently small difference in how it was framed dramatically affected how students handled their windfall.
Of those who considered it a bonus, 84% of them spent some or all of the amount. From the that viewed it as a rebate, only 21% spent any money at all.
Imagine yourself at the receiving end group of a windfall – let’s say Rs 5 lakh. If you won a lottery, would it not get a different treatment had you earned this as an annual bonus? The chances of you splurging in the first instance are much higher, though the amount of money is identical in both instances. That is because when we earn the money, we are more likely to put it to practical uses. If it was won, found, or given to us, we are more likely to spend it for enjoyment.
The truth: Money does not have labels. We assign labels depending on how it came into our possession and how it makes us feel.
#3. Money is treated differently, depending on what something costs.
Let’s say you went to buy a lamp and narrowed down on one costing Rs 1,500. You were told that if you visit another store five blocks away, you will get the identical lamp for Rs 1,000. There is a strong likelihood you would make that walk.
Now, instead of a lamp, assume it was a sofa that cost Rs 25,000. You can still walk five blocks away to get it for Rs 500 less, but you would not bat an eyelid.
In both cases, you would have to walk five blocks to get a discount of Rs 500. But despite the amount (and the effort) being identical, Rs 500 seemed to have less value next to Rs 25,000 than it did next to Rs 1,500.
The truth: When we view it in percentages, our perception changes. When Rs 500 is 2% of the entire deal, it is viewed with less importance than when it is 33.33% of the cost.
#4. Money is treated differently, depending on how we lose it.
Even loss is placed in a mental account.
Let’s say you lost a Rs 500 ticket to a concert. You are not likely to buy a new ticket unless you are desperate to watch the show. Let’s say you did not lose the ticket but lost Rs 500 on the way to buying the ticket. Chances are you would still buy the ticket.
Why? In both scenarios the loss is Rs 500.
In the former, you would tend to think that Rs 1,000 is too large an expense for the concert (mental account: entertainment). While in the latter, Rs 500 is the cost for entertainment, Rs 500 just turned out to be an unfortunate loss.
Princeton University conducted an identical experiment with the issue of $10 being spent on a movie ticket. They discovered that only 46% of the study participants in scenario one said they would spend another $10 to buy another movie ticket. However, 88% of the subjects in scenario two said they would still spend $10 to buy a movie ticket.
The truth: Money is fungible, but we fail to see it as interchangeable.
So what must you do?
Mental accounting is a shortcut that our brains use to try to make sense of things and assign meaning and order to the world. Yet, it has significant repercussions because it is often emotionally driven and can lead to illogical, or even damaging, decisions. How we view money impacts how we put it to use. So take control.
Set a predetermined rule for any windfall - inheritance, gift, bonus, rebate, refund, lottery. Don’t leave it to your whims and fancies. Assigning money to a pre-set purpose will lead to a healthier bottom line.
- How much (%) for splurging.
- How much (%) to retire current debt.
- How much (%) to be invested.
When it comes to looking at the amount of a discount, think about what else you can do with that money. In the above case, it was Rs 500. Sometimes it is sheer laziness that makes us take the shortcut. But if you visualise what could be done with that saving, you might act differently. You can still go ahead and forego the discount, the trick is to be aware and question your decisions so that it leads to a healthier financial outcome, or at least a more well-thought out convenient one.
Larissa Fernand is Senior Editor at Morningstar India. You can follow her on Twitter.
