Hello friends, in today’s article, we see mental accounting in the stock market from chapter 7 of the book stocks to riches by Parag Parikh. In this, we understand, how we lose lots of money, by mental accounting error. This bias helps you to understand behavioral finance and get the idea of saving money and investing also.
so let’s start
Mental Accounting:- Stock to riches Chapter 7
In this, the author (Parag Parikh) gives us some instances ( examples ) to show how mental accounting works,
Dilip has just taken an MBA in finance. He was intelligent and had a sixth sense when it came to picking stocks. He worked for a brokerage firm and was respected for his ability to read the markets.
After a couple of years, he married Sonia. At that point in time, he had around Rs. 2 lakhs in his bank account. the year was 1991 when the process of liberalization had begun and the stock market was just taking off.
Being adventurous, Dilip decided to use his savings to trade in stocks. It was a wise decision considering his track record as a stock picker and his past success with the brokering firm’s clients. In the first year, his capital increased to Rs. 8 lakhs.
In 1993, his capital rose to Rs. 14 lakhs. two years later, confident in his success, he quit his job to become a full-time trader.
Sonia did not agree with this decision but he told her this would give him more time to develop his skills by attending various seminars and keeping up with his reading which was so very important.
he continued to do well and in 1994, his capital increased to Rs. 30 lakhs. the couple went on a trip to London. Sonia was very happy as they had moved to their own one-bedroom apartment.
In 1995, his capital soared to over Rs. 60 lakhs and so did his confidence. Being conservative, Sonia preferred to play safe. She insisted that Dilip should put aside some money in different safe assets, which they could fall back on in times of need. She was against Dilip investing all their capital in the stock markets.
Dilip did not heed her advice. He thought the higher the investment the greater the profit. Their different approach to money created a rift between them.
Arguments followed and the relationship was strained. Dilip’s winning streak ended and he began to lose. But he thought that since he had a comfortable balance there was no need to worry.
he betted heavily in a market that was going down and by 1997 he had lost everything. His flat was mortgaged to a financer, and Sonia filed for Divorce.
She accused him of being a compulsive gambler who lacked the financial prudence to take care of his wife. She said he could not handle money and had lost Rs. 60 lakhs in just two years in spite of her warning to save for their future.
Dilip was shocked. he had only lost Rs. 2 lakhs and that also over a period of six years.
so while reading this example, we don’t know about mental accounting, so for this author to give the explanation, just wait for more two examples, then we get the three examples and their explanation.
Sunil and John were good friends. they worked for the same company and were financially sound. they enjoyed the good life and decided that every Saturday they would dine at a five-star restaurant. Each would pay the bill every alternate week. The first Saturday they dined at the Taj and Sunil paid the bill of Rs. 3000 with his credit card. the next Saturday they dined at the Hilton and this time john paid the bill of Rs. 2800 in cash as he did not have a credit card. the following Saturday the bill was Rs. 4200 and Sunil paid with his credit card. Next when john was due to pay, once again he paid the bill of Rs. 3900 in cash. After a couple of more such Saturday bashes, John told Sunil that they should quit going to five-star restaurants as it was very expensive. Sunil disagreed. He felt they needed this recreation and that they could afford it. He insisted they carry on and John gave in much against his wishes. The next time Sunil had to pay the bill he forgot his credit card and paid cash. the following day he told john that he agreed with him about staying away from five-start hotels.
These examples also do not give direct thought to mental accounting,
let’s see example three
Bomsi was a spectator at a cricket match. He had with him a bag in which he had carried his provisions for the day. During the game, he was seen talking loudly and frequently on his mobile phones of which he had three. Suddenly, in the midst of an interesting over, he was heard arguing with an ice cream vendor. the dispute was over price. Bomsi showed the vendor this bag and told him, ” I have bought everything from home, even water. The only thing I can’t bring is the ice cream because it melts. But I will not allow you to cheat me.”
Now Bomsi was a cricket aficionado. he cheered both teams enthusiastically. After the lunch break, a player completed a century and Bomsi was ecstatic. he called the ice cream vendor, grabbed his bag, and generously distributed ice creams all around.
Within the next three hours, he did this twice more. After the game ended he settled his bill with the vendor and even gave him a hefty tip. this man who had fought over the price of ice cream in the morning had distributed ice creams by the dozens to people he did not even know. When asked about what he had done, he replied, ” I love cricket and I love to gamble on the game. When I win I like to celebrate. all my bets paid off. It’s the bookies who are now paying for the ice creams, so let the people enjoy.”
after this example, the author gives the idea of mental accounting
the author says, ” Mental accounting is an idea developed and championed by Richard thaler It underlines one of the most common and costly mistakes people make when dealing with money. it’s the tendency to place different values on the same sum of money depending on how it has been acquired and the effort required to acquire it.
Traditional economic theory assumes that money is fungible, meaning that one type of monetary unit can replace another. this means that Rs. 100 in lottery winnings, Rs. 100 in salary and an Rs. 100 tax refunds should have the same meaning as they have the same purchasing power. but studies indicate this is not so with individuals. People mentally separate their money in different accounts, giving each account a different significance.”
The three examples mentioned earlier
demonstrate how mental accounting affects people’s behavior, the author explains
the author says, ” Going back to example one Dilip started with Rs. 2 lakh and now has nothing. to him, his loss is only Rs. 2 lakh because his gains in the stock markets were merely his winning from his original capital and so not his own money. He treated the two accounts separately Sonia, however, does not suffer from this bias.
In example 2, every time john paid the bill with hard cash he felt the pain of seeing money go out of his pocket. Sunil did not experience this pain when he used his credit card. But When he paid in cash he understand the pain of parting with the money. and his attitude changed. In our minds, we distinguish between cash accounting and credit card accounting. Actually, both are the same, but we view them differently because of our mental extravagant when we use a credit card.
In example 3, Bomsi was stingy with his own money. But when he won, he become very extravagant. to him, his winnings were not his own money but that of the bookies. Hence the celebration mentally, he accounted separately for his own money and for his winnings. Let’s see what you would do in the following two situations.”
After this, the author gives the two situations to understand the mental accounting regarding money.\
Situation A:- You have paid Rs. 500 for a movie ticket. When you reach the theatre. you find that you have lost the ticket! Would you buy a new ticket? or would you prefer to go back?
Thinks about this, and keep your answer in mind.
Situation B:- You go to the theatre to watch a movie. when you reach the ticket window you find that you have lost Rs. 500 out of the Rs. 2000 you were carrying. would you still buy the ticket?
now think about this also and give the answer to yourself.
and check is right or wrong from the author’s explanation.
the author says, ” Most people would say no to the first situation and yes to the second.
However, both entail a loss of Rs. 500 and the cost of Rs.1000 to watch the movie. So why take different decisions? Because most people segregate the loss of the ticket and the loss of cash into independent categories or accounts and therefore react contrarily to the two situations.
Mental accounting is directly correlated to our emotional state. to understand it better, let’s consider different types of mental accounts and the human behavior associated with them.”
So for better understanding, the author gives us real-life experience and how mental accounting is work.
Earned Income V/s gift Income:-Mental Accounting in Stock market
in this, the author says, When we receive our salary cheque we are careful how we spend it. For we that money is sacrosanct, the fruit of our hard work.
But if we got a gift of the same amount of money you would treat it very differently we may spend it lavishly.
Mentally, to us, this is free money, but our salary money is not what we earned it, hence mentally we put it into a different account.
So this type of mental accounting has so many times happened to me. I know you also face this type of mental situation.
let’s now talk about other experiences.
Quantity of the money in Question:-Mental Accounting in Stock market
In this, the author says, ” we create mental accounts according to the quantity of the money and treat them differently. A tax refund is a tax-deferred payment by the tax authorities.
But when we get a tax refund of say Rs. 1000 we are likely to spend that without giving it due thought. However, a tax refund of Rs. 2000 will set us thinking, whether to deposit it in a bank or buy mutual funds and stocks, we do this because Small amounts go into important decision accounts.”
so this type of mental thinking really happens in our life, so now we know that then from now we know this, then think before spend and remember this mental accounting.
let’s take another example in real life
Large Purchases V/s Small Purchases:-
In this, the author says, ” When you want to buy a fridge you make a lot of inquiries before making the purchase you check out models and prices and even brands when you have found the one you like you to do some hard bargaining and maybe get a discount of Rs. 500 on a fridge costing Rs. 20,000. That makes you happy, but do you do the same when shopping for groceries do you realize that if you put in a little effort and are able to save Rs. 10 a day, at the end of the year, it would add up to a savings of Rs. 35000? Compare this with the saving of Rs. 500 on an expense that may not recur for the next 10 years or so.
Many people are cost-conscious when making large financial decisions, but they relax their discipline when it comes to small purchases. but that’s where the difference matters.”
These things also happen with us.
let’s see about credit card and cash example
Cash V/s Credit Cards:-
In this, the author says, ” Today credit cards are a status symbol. Everyone wants one, and every book is aggressively marketing it. It is a big profit earner for the bank and a hole in the pocket for the user who is not aware of the harm it can cause remember the example of Sunil and John
Sunil realized the value of money only when he paid the bill in cash. Because we have different mental accounts, we treat cash and credit card transactions differently. People tend to shop more. If they use credit cards as against paying cash. Actually, both represent your own money. It’s just that credit cards make us extravagant since we don’t see the money change hands. Moreover, we pay interest on the credit offered it is for this reason that credit card companies do a flourishing business.”
lastly, the author gives the Sacred money examples
in this, the author says, ” Ramesh was a successful investor and had done reasonably well for himself. One day he inherited Rs. 10 lakhs from his uncle. The uncle had worked hard and saved his money all his life. He did not take any risks and looked after this money with care.
Ramesh treated this money as sacred as he had received it from someone. who had toiled all his life to earn it? He would not consider putting it into the stock market where he had done reasonably well. Instead, he put it into bank deposits. The money was marked ” Sacred ” in his mental account. Had his uncle been extravagant may be Remesh would have played the stock market with the money”
After this, the author gives the impact of mental Accounting on Investors.
Impact of mental accounting on Investors:-
In this, the author gives, four examples of the impact of mental accounting
the author says, ” Mental accounting affects not only our personal finances but is more pronounced in the world of Investments.
- Why do investors hold on to losing investments? They may offer various reasons to justify their action but the fact remains that mentally they are unwilling to accept that they are making a loss. Mentally we tend to believe that we book a loss only when we sell. Intellectually we recognize the loss but we hope that it will vanish. this is a common mental accounting error.
- Why do investors earn less interest and pay more? Ravi is highly educated, has a successful career in margin trading, and is a savvy investor, in spite of the high interests paid by him, his returns from the business seem quite handsome. Being conservative he prided himself on having comfortable bank deposits to take care of any unforeseen eventualities. He knew that the bank deposits offered a lower rate of return but he felt that was a price he would pay for the margin of safety, that banks offered. It is ironic that he pays high interest in his margin trading while his own money earns a much lower interest in bank deposits. How much better he would be if he utilized his own money for his own stock trade and avoided paying such high rates of interest. this is not a stray case; most people make such mistakes. The problem is that they have two mental accounts. – ” Safe Money” and ” Risk Money ” – For the same money ( it’s also called mental accounting)
- Most people believe that a bonus share is a freebie given by the company to its shareholders. they even buy moe shares on such news but they are dead wrong. Companies give bonus shares to capitalize reserves and balance their finances. But investors don’t see it that way they consider it to be a windfall. This leads them, to become extravagant. Most investors suffer from this mental accounting error that’s why the stock markets rise on such announcements.
- Day traders trade in and out of a stuck time and again, with very narrow spreads. they think that they are generating income profitably. but consider the transaction costs and the brokerage they pay on such volumes. What they are in actually is the business of enriching their brokers. and the tax authorities. It’s like buying groceries not heeding the cost.”
Then the author gives the plan of action and advice
let’s see advice first
the author says, ” Before discussing the plan of action it is important to understand that there are no set rules. the best advice is to refrain from using credit cards and to treat all monies equally.
We all have our individual faults and we have to decide what we need to do for ourselves. mental accounting also has its positive and negative aspects and it is up to each individual to know what is best for him for instance, If you are a big spender and unable to curtail your urges, mental accounting could be the most effective way to plan your fixed mortgage payments kids education fund and retirement savings.
In order to eliminate the harmful effects of mental accounting while preserving its benefits you need to audit your own mental accounting system.”
Then the author gives the plan of action for mental accounting, to avoid our loss
you can read this plan, in the book, buy the book, from the following link ( image)
so this is all about the mental accounting from chapter 7 of the book ” Stock to riches”
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