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Assume
that one day you will go to an appliance store to buy a
large electric fan, which sells for P2,000. At the
store, you learn that the same fan is on sale for P1,500
at another branch of the store 300 meters away. Would
you go to the other branch to buy it at a lower price?
You are
on the same appliance store to buy a modular kitchen
set, which sells for P99,000. You discover that you can
buy the same modular kitchen for P98,500 at another
branch of the store 300 meters away. Would you go to the
other branch to buy it at a lower price?
A
similar study was done under these two circumstances and
the result was that most people would travel for the fan
but would not travel for the modular kitchen. If you
come to think of it, both scenarios offer the same
amount of a P500 saving.
Most
people are mindful of their costs when buying
large-ticket items, such as houses and cars. But mental
accounting causes them to relax their cost-consciousness
when buying small items such as daily food purchases,
recreation spending and clothes. The thing is, though
you buy your car or your house every few years, you
actually buy groceries and clothes weekly or even daily,
and these small amounts do add up.
Mental-accounting principles also affects payments
received. Studies show that individuals who receive a
larger amount of money (such as from bonuses, rebates or
gifts) will have a harder time spending it than those
receiving smaller amounts. If you get a bonus of P1,000,
chances are you might simply treat your friends out to
dinner. If you get P100,000, you might actually deposit
it in a more serious long-term account.
Mental
accounting is the tendency to value the same amount of
money less than others. It refers to the tendency to
compartmentalize and treat money differently depending
on the source, on its location and the manner of
spending.
Humans
will have difficulty calculating the impact of every
transaction, such as watching a movie, or choosing
between drinking free water and ordering soda, against
the size of every long-term objective, such as
retirement planning. In order for us humans to cope with
this immense organizational chore, we have segregated
our money into mental accounts. We treat a peso in one
account differently from the same peso with another
account.
But
there is a downside in our natural tendency to apply
mental accounting. As an example, we’ll spend P1,000
received as a gift with less thought than the P1,000
earned from a job. Think about it. Why should you treat
them differently when, in fact, they have the same
amount of buying power?
Some
mental accounts are dangerous, such as the credit card.
Credit-card pesos are seen with lower value as you don’t
feel you’ve lost something at the time of your purchase,
at least on a physical level. If you have P3,000 cash in
your pocket and you just paid P2,000 for an MP3 player,
you experience that only one of your three P1,000 bill
remains in your pocket.
However,
if you charge that MP3 player to your credit card, you
won’t experience the same loss of buying power cash
brings. You feel that you’re not actually spending
anything when you use cards.
An
experiment was conducted by Drazen Prelec and Duncan
Simester at the Massachusetts Institute of Technology in
Cambridge, Massachusetts. They organized a real
sealed-bid auction for a basketball game ticket.
One-half of the participants were told that whoever wins
would have to pay the amount in cash while the other
half were told they would have to pay the amount by
credit card. They averaged the results of cash bids and
credit-card bids. Unsurprisingly, they found out that
the average bid of the card was roughly twice as much as
the average cash bid. Their experiment proved that
credit cards turn us into bigger spenders than we
already are.
Do you
have savings in the bank and unpaid revolving balance on
your credit cards? Do you spend more using tax refunds
than with your savings? Do you spend more when you use a
credit card than when you use cash? Do you think you’re
not a big spender, but you always seem to have trouble
saving?
Then
you’re a candidate for someone who has a tendency to
fall into the mental-accounting trap.
Do you
have an emergency fund in a savings account? And do you
carry previously unpaid balances from your credit-card
account month to month? If you answer yes to both of
these questions, then you are suffering from the dark
side of mental accounting.
You are
putting higher value to the savings account and a lower
value to your credit-card account. Assuming you are
earning 2 percent on your savings account and you are
paying 20 percent annual interest on your credit card,
if you have P10,000 unpaid balances on your credit card,
you are losing P1,800 every year. If you simply pay off
your high-interest credit card using your savings
account, you have just made P1,800 in 15 minutes. (Why
15 minutes? Well, 15 minutes is about the time it took
you to read this article.)
(None of
the information presented here is intended to serve as
the basis for any financial decision, nor does any
information contained within constitute an offer to buy
or sell any security.)
Josefino R. Gomez is a Certified Public Accountant, a
Certified Real Estate Broker and a Certified Treasury
Professional. Questions about the article and other
queries may be e-mailed to josefinogomez@yahoo.com.
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