When I caught up with some friends, a curious discussion on money and savings came up. I asked them how they treated their money — whether as a big pile and spend from that or bucket them into sources and spends. One friend said, “cash in, cash out and if lucky, some savings.” Another friend said, the salary is usually for household expenses and EMI. The rental income is set aside as an investment for daughter’s education. If you did the latter, you may be engaging in the interesting activity of mental accounting.
Instead of treating all money as purposeless blobs that transit through your account, if you separate your pool of money into buckets, either based on the source of the money or what you intend to do with it, you are lending purpose to the unit of money. In the world of savings and investments, this can be a smart thing to do.
Spending limits
Let us look at the benefits of mental accounting when it comes to spending. In the days when credit or debit cards were not available, you may have seen your father or grandfather put money into neat covers and write ‘rent,’ ‘milk and vegetables,’ ‘electricity’ and a handsome ₹100 for emergencies. This mental accounting imposes discipline on how we spend, and more importantly, provides a tremendous mental reward system when you actually save anything kept for any of these buckets. It encourages you to save, even if it is to reward yourself with some other purchase.
While your spending today happens through cards or UPI, you can still use apps to fix a limit and keep track of your spending — category-wise (clothes, entertainment, food etc.). It is no different from tracking your mobile data usage after fixing the limit.
If you are a parent with a teenager or a college going kid, this could be a great way to start teaching budgeting and the need to save; giving them some incentive for saving. Needless to say, you could do with the same discipline too!
A far more significant benefit of mental accounting, if used well, happens in investing. Three things happen when you invest with goals in mind: one, you know how much you need to save and fine-tune your savings, you know when you need to achieve it and most importantly, you know what financial products to choose, to save for the goal. Most of you go to your adviser or relationship manager saying you have some surplus and want to invest. You seldom have an idea on what you will use it for (here you treat money as a common pool), or when you will need it. Let us suppose you are sold a money-back policy. Three years hence, you are short of money to pay the hefty fee demanded by your child’s education institution and want to surrender the policy. You are told you will be given just 30% of the premium paid, excluding the first year. That essentially means you lose out even the money you paid as premium besides the fact that the money would not help you meet the immediate financial goal. So, what went wrong? You did not do the mental accounting of segregating the purposes for which you were investing. If you had done this, the purpose would have had an end date. If you knew this end date, then you would have chosen the right investment product and would have got the money with some returns (without deep discounts or losses) when you needed it. If you knew your medium-term goal was to get admission in a premium school for your child in 2-3 years, then you would have an idea on how much is needed and you could have followed up with saving more.
Also, the question of locking it into long-term insurance products or high-risk products and losing money or getting a poor deal would not even arise. For example, in this scenario, I’d simply tell you to go with low-risk deposits or fixed income product, since you have no leeway to go for high risk or long-term products. This is the key ‘make or break’ point for your financial goals and wealth building. Having no goal often leads to wrong choice of products.
The other big advantage with mental accounting is that it reduces the temptation of digging into your investments for impulse purchases. For example, I knew an investor who was saving diligently for the higher education of his two children. We specifically tagged the portfolio as education portfolio of his son and daughter respectively and tracked them separately. He once told me he opened his portfolios on his app to withdraw ₹12 lakh to buy a new car. But when he saw the ‘education’ tag screaming at him, he closed it. He postponed his car buying indefinitely. That to me, is the benefit of mental accounting. You stay committed to your goals. Try starting off today with this simple action of segregating the money you get into specific purposes. See the difference it makes to your life, five years from now.
( The author is co-founder, Redwood Research )
