Suppose you inherit a certain sum of money, or win a lottery, do you think you will treat it the same way you treat your salary? Will you use this sum as prudently as your salary or in a more risky manner?
Mental Accounting Bias leads investors to treat money differently depending on where it comes from. Due to Mental Accounting Bias most of the investors segregate money into distinct groups based on the sources or uses of funds and apply different rules to them, rather than rationally viewing every rupee as being identical in value.
Investors tendency to segregate or categorize money differently can result in divergent behavior while investing. For example, investors who receive any unexpected tax refund or monetary gift or special dividend or any other onetime gain might take more risk with that money or be speculative with it. On the other hand, investors investing money from their regular income source such as salary would invest the amount with much more caution.
Even though money has the same buying power irrespective of its source, investors typically attribute relative values to the money based on its source. As a result, investors may tend to be too conservative or too aggressive while investing. For example, investors might be investing all of their retirement savings in conservative avenues such as fixed income instruments, even though most of the times, the returns on such investments might be less than the growth in inflation. On the other hand, they might invest in an aggressive manner and indulge in speculation, if they have surplus funds that are derived from one time gains.
An example of how mental accounting bias works against an investor while investing is as follows: An investor has bought a stock at Rs. 100 and the stock has gone up to Rs. 200 and the investor who had anticipated the stock to rally higher did not sell the stock, thereafter, the stock corrected to Rs. 120. Due to mental accounting bias, the investor does not assume to have lost Rs. 80, but would think of gaining Rs. 20 i.e. since the capital is only Rs. 100 and considers the price of Rs. 200 as a notional gain. As a result of mental accounting bias, the investor would usually not take precautions to protect profits from the Rs. 200 level.
Mental accounting leads investors to hoard money in a Savings Account that earns 4% interest, while keeping an outstanding balance on a 18% – interest Credit Card. Because of mental accounting bias, investors like the psychological comfort they get from having money in their savings account, even though transferring cash from the savings account to pay off the credit-card balance can essentially save them nearly 14%.
Used judiciously, investors can also take advantage of the mental accounting bias by linking money to be saved to a particular goal such as buying a home and children’s education. This would result in motivating investors to save more money rather than spending it.
Investors should have a proper asset allocation and investment strategy to avoid any negative effects of mental accounting bias. Investors can also overcome the adverse effects of mental accounting bias, by having a designated monthly investment allocation into different investment plans for achieving their financial plans.
If investors treat all income, irrespective of their source, as hard earned money, they can avoid being adversely affected by mental accounting bias.