Notebook of a Share Trader

Mental Accounting of Money

All money are not same. How do you behave with your money, it depends on how did you get that money.  The purchasing power of 100 bucks will be the same, no matter from where you have got it. Whether from salary, borrowed or lottery winning. But studies show that it is not same with individuals. People mentally separate their money in different accounts, giving each account a different importance.

We, in stock market deal with money, invest our money, to earn more money. How do we behave with our own money from our mental account. Mental account differs the way, we invest our money or spend our money. Mental accounting theory can help us making better decision in investing and managing the risk. These are the topics, how do we behave differently with money :-

1. Original capital vs. Profit from the Stock Market
2. Paying Cash vs. Paying through Plastic (credit card)
3. Earned Income vs. Gift Income vs. Lottery Winning Money
4. Small Amount of money vs. Big Amount of Money
5. Large Purchases vs. Small Purchases

Because of the mental accounting bias, people have design in their brain about the investment strategies. Even if they will ignore the advise from financial advisor to remain properly diversify and many more things that they would be need to do as a professional investor.

Original capital vs. Profit from the Stock Market

A first investment is very carefully tickled by the the investors and as he make money on stock market, he relaxs his discipline of investing. Even he spend the money of the profit which is not actually realised by completing transactions. The investors have bias two account in his mine one of which consist of his own capital and another account of his profit. Sometimes, he takes decision to sell the portion of shares, merely to protect the his own capital out risk from the stock markets. A investor who makes money in his first attempt never care to calculate cost of capital he has raised.

Paying Cash vs. Paying through Plastic (credit card)

Through credit card consumer tends to spend more money than cash payments. On your purchases on grocery store you buy extra and you can afford to pay higher bill in restaurant through credit card, even though you have to pay your credit card bill also. The same bill if you pay by cash your mental account disagree to pay and you become conservative on expenses. Today, credit cards are a symbol of status. Everyone wants some credit cards and every bank is aggressively marketing it. It is big earner for the bank and a hole in the pocket for the user ho is not aware of the harm it can cause.

Earned Income vs. Gift Income OR Lottery Winning Money

When you receive your hard working salary cheque or income from business, you are very careful how you spend it. But if you have gift , bonus or tax refund you might tend to spend it lavishly. Here, mentally you put the money the money into different account. The winning money of lottery, casino or gambling of cricket are spend extravagantly, as money are not your own and your own earned money are spend and invested very wisely.

Small Amount of money vs. Big Amount of Money

Size matters, in case of the quantity of money you receive as dividend or tax refund. People create mental accounts according to the quantity of the money and treat them differently.  When you get dividend of Rs. 5000,  you like to spend that without giving it next thought. But, will you do the same thing if you receive Rs. 50,000 ?  Definitely not, you will plan to deposit in a bank or invest in mutual fund or stocks.

Large Purchases vs. Small Purchases

When you plan to buy LCD TV, you make lots of inquiry and check out for models, brands and prices. Finally, you decide to buy one you start bargain on it. Probably, you save Rs.500 out of purchase of LCD  TV of Rs. 30,000.  Bargain gives you satisfaction of buying little cheaper. On the other hand, when you buy groceries you hardly bargain. Do you realize that if you put little efforts to buy grocery you can save at-least Rs. 10 or 20 a day. How much amount can be saved by a year? Instead of bargaining you have also choice to buy all grocery of the month from the discounted stores.  Compare this saving with purchase of  TV  and saving in long term with grocery. Many people conscious in case of  making large finance decision and relax themselves in case of small purchases.

As a human being, we all want to be happy and money is inevitable part of being happy. Most of the problems arise due to the financial problems. There are main three elements of the problems Mental, Physical and Social.  Physical and social problems can be easily solved once the monetary problem is solved and you remain peaceful if the monetary problem is solved.

Study says, the pain of loss is three time more than pleasure of equal amount of gain. Over the time, pain becomes terrifying and pleasure becomes boring.  To avoid pain from losses, one should take the losses in a one stroke and profit in parts.

How many times do you think of money in a day? Why do you invest in the stock market? Naturally, to make money. You must be aware of any decision you take, there can be a emotional reason behind it. People mentally separate their money in different accounts, giving each account a different importance.  This idea was developed by Richard H Thaler

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