Understanding Mental Accounting Bias

Have you ever come across people saying things like, I won Rs 1 Lac in a casino, I'll give a grand party to my friends with the money; or I can afford to lose 20% of the total money I invest, let's invest it in riskier assets; or I have kept Rs 10 Lacs for my 15 year old daughter's wedding ought to happen 10 years hence, in a savings account, I just don't want to take chances. These decisions are completely irrational, this is not how one must put his/her money to use, to make the most of it. Rather than connecting the investment decisions with the horizon of their goals, risk appetite, return percentage needed to create the required corpus, etc., investors are basing the decision on where they got the money from and what is the purpose it's going to serve. How ridiculous is that. You must have encountered such statements and explanations multiple times over your career, but before judging the investors or countering them with logics, it's important to understand their psychology. These people are being biased, they are under Mental Accounting Bias.

Mental Accounting Bias is the tendency to categorize money into different mental accounts on the basis of it's source or the intended use. Let's understand Mental Accounting Bias with the help of a situation. For Example, post work, you feel like having a cup of coffee. Now, consider two scenarios:

1. You stop at a cafe, you pay Rs 100, pick up your coffee and as you turn to leave, a young kid playing around, bangs into you and you spill the entire mug.

2. On your way back from office, you lose Rs 100, before you reach the coffee shop.

Now, in both cases, will you spend another Rs 100 for a cup of coffee?

Most people would not spend Rs 100 in case 1, but they would spend in case 2. Because, in case 1 they feel that they are paying Rs 200 which may not seem worth for one cup of coffee. In case 2, they have lost Rs 100, which is a different account, for the coffee they are paying Rs 100 only.

Similar is the situation of the above investors, but buying the coffee or not doesn't have any material repercussions, however basing investment decisions on the basis of mental accounts may have serious consequences.

Usually people are cautious while spending money when the source is their salary or business income, however, when the money is uncustomary in nature, like bonus, tax refunds, winnings in lotteries, money received in inheritance, etc., we become lenient in spending the windfall. So, when your investor is making vacation plans from the bonus money he's received, he's actually attributing the money into a mental account based on it's source. It is very important for the advisor to punctuate the investor at this point and remind him about his urgent commitments and goals, the personal loan due or the credit card bill outstanding needs attention at this point, or his goal of buying a home is a priority for him, and the bonus is a good opportunity to unburden him of the debt/feed the home goal.

The above was about mental accounts created on the basis of source of the money. Investors also attribute using money on the basis of it's use to various mental buckets, children school fee money, cousin's wedding expense money, new years party money, and then we apply different rules to different buckets. In this case, we are careful with the former and more indulgent with the latter. Investors extend this phenomenon to investing also, they are strictly risk averse for some investments irrespective the goal is decades away, like their retirement, it all depends on the criticality of the goal for them. The solution is educating investors, it is important for advisors to explain to the investor about the need to invest in riskier investments with better return generation potential for their long term goals. It is at the same time important to let them know that risk is risky in the short term, over the long term, growth prevails, because investors don't want to leave any room for error, when the goals are absolutely uncompromisable. Investor education from the time you get them onboard and onwards is critical to keep them away from such biases.

Use it to their advantage. Mental Accounting Bias has a positive side to it as well, it can help investors remain focused towards their goals. There are times when investors are willing to stop their SIPs or redeem their investments mid way, either for some other commitments that may have cropped up or because volatile markets are bringing the value of their investments down. These are the times when mental accounting can be used to keep them on track by recalling to them their goals and the implications of compromising their investments. When you tell them, the purpose behind the SIP was their retirement, by stopping the SIP they are hampering their retirement goal, they will most likely re-consider their decision of stopping it.

To conclude, it's important for us to understand investors' bias towards the mental accounts created by them and the fact that it's easier for them to manage their expenses and investments that way. It's only after you are familiar with their mental accounts, that you can target them individually and help investors overcome the trap.

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