Mental Accounting : How brain understands and evaluates money.

I was going through "THE INTELLIGENT INVESTOR" by Benjamin Graham which I recently bought and it had something so peculiar mentioned in it, and that too in such a wonderful manner, that it made me drown myself into self-evaluation.

What was discussed was not a financial jargon, just plain logic, some of which was obvious, and some a revelation. The analogies were simple and at the same time astonishing. Could not help myself sharing it.

It discussed in detail "MENTAL ACCOUNTING" i.e. how does a common brain (like mine) functions, in matter related to day to day accounting. It brought about a few examples explaining the common mistakes that we make everyday; which, if avoided to make us a lot richer than we actually are.

Example 1:
The fundamental concept in Economics states that whatever be the source of income, wealth in general, holds equal value in terms of purchasing power. To make it simple, whether is a hundred bucks earned by salary, or by lottery it has the same value in the market, irrespective of the source that it comes from.

But, the question is, do we treat it in the similar way??

While the hundred bucks earned in the salary are precious to many of us (not all). The hundred bucks earned in lottery or say a lucky draw do not hold the equal importance, as most of us (again not all) are likely to spend it without even thinking twice about the value it has, even if its comparable to the salary. To be precise, the source of money determines how it would be spent. In a similar manner, we tend to literally throw away the food coupons, neglecting the fact that we would have never spent the same if it were cash. Also, credit cards are the best means to spend more than we intend to.

All this is so because we tend to value cash more than other equivalent sources, which hold similar value. And this is nothing but "Mental Accounting". Our brain presumes that we are just consuming or bringing to use a certain resource, while the fact it that we are actually wasting a lot more than we usually do.

Example 2:
Yes, I know, all my friends who work at some place or the other have realized what I have written above, but those who are still in college or school might not gain much from it, as it is though to associate with your current situation.

So, here is a simpler example of "Relative Cost". I can explain this with a simple example. Lets say you want to buy a bike which costs say Rs 70,000. You get to know that a showroom which is 2 kilometers away and sells the same for bike for 69,950. I am certain that most of us (again not all) would take it from the showroom which is nearer because it is just a matter of 50 bucks. But, in a similar situation, we get to know that a shop 2 kilometers away, is selling a pen-drive worth Rs 100 in Rs 50, most of us would rush to get it the same day.

What is worth an observation is that in both the cases, the customer would save Rs 50. Which has the same value in market. But in one case, it seems lucrative whereas in the other case it seems worthless. All this because our brain makes us think that way.

Interesting, isn't it?

Having seen the examples above, I believe we can put our brains to better work, utilize the funds effectively and not get lured by what our brain forces us to believe.