Make investing a habit and, spending, a conscious decision in order to avoid the perils of splurging whenever you receive a lump-sum payout

 

Last week, I finally found the long lost PPF passbook. It was lying hidden within files that held in vestment papers from the pre-In ternet times. I had opened the account in the late 1990s and had contributed for 10 years. When we moved home from Navi Mumbai, the passbook got misplaced.Though it remained at the back of my mind, I did not act on it. I felt guilty about it sometimes, but consoled myself that the money is there and I will recover it some day. When I made the trip to the bank finally, and recovered the princely sum, I felt gleeful. I am now going to use it to buy stuff I have never bought before. Stuff I wanted but never had the courage to buy. Welcome to the world of mental accounting.

We all are human and tend to have our frailties when it comes to money. Mental accounting refers to our tendency to treat money differently depending on how we got it, despite the rational reality that money is money irrespective of its source. Winners of lotteries and prizes know it only too well. Not only do they indulge in luxuries for themselves and their families, but are also forced to support business ventures and needs of the extended family. Everyone sees the money as "free". Almost as if the winner is obliged to give it away. It is unlikely that we will treat salaries the same way.

We all celebrate bonus payouts with treats for ourselves. We like to get gifts that represent things we might not have bought ourselves, even if the family kitty was used to fund it. We do not mentally treat money as fungible and belonging in one box. There is one box into which salary and income goes, and we are careful and cautious about it. There is another into which unexpected gains go into, and we spend that money very differently.

We actually like mental accounting. We think it provides a good framework for discipline and good behaviour. It is common for people to leave money in the bank fixed deposit at 8% and take a loan at 11%. If all that was needed was the money, rational choice dictates that we break the deposit and use the money. We can always build that deposit back, just as we would repay the loan. We will save the 3% additional interest we pay.

But in reality, we worry about our lack of self-control. We tell ourselves that we will not touch our savings. We take the loan so that the discipline of repaying is imposed.We are not confident that we will actually build back the deposit if we break it. Loan against deposits, or overdrafts are sold by banks routinely to customers who come in to break their fixed deposits. Our mental limitation is their advantage. Investing for children, buying a house early, opening multiple accounts, earmarking investments for specific goals, are all practices that arise out of our need for mental accounting. Treating all our money as one pool is not what we are comfortable with. Perhaps we can use this tendency to our advantage. Here are a ways to do that.

First, imagine a pool that is meant for our use when we retire and visualise it like a pot of gold that we will dig up only when we stop working. The trick here is to tell the mind to not look in. To create a mental account, such visualisation is important. It is important to set the date in our mind and reinforce the idea that before that date the money will not be accessed and we will show no eagerness to know what is there and how it has grown.

Pause for a moment and recall your PF balance. Quite likely you do not know how much is there. This precious pool for our retirement is accumulating, because we mentally have earmarked it for access only when we retire. The only sad reality is that it may not be enough. Use mental accounting to create another pool, this time in equity funds, and contribute to it, every month, just as you would do if you chose VPF. The nice surprise at retirement is so worth it.

Second, whenever there is a lump sum payout such as a bonus or an incentive, set a rule in your mind that 50% of all of such lump sums belong to your children, or if you don't have kids, the charitable cause you like to support. If you trained yourself to only plan for 50% of the money, you will find that your default savings are moving up. You will soon get into the habit of putting aside half of your annual incentive for other uses, rather than spend them all.

You will also realise that talking about it hurts your ability to be disciplined, and setting up an investment plan to utilise the money as soon as it comes in works to your advantage. Such is the power of practised discipline and self-control and you may soon find yourself allocating more to saving and investing and less to spending.

Third, always bundle up your investments and savings into income accounts, instead of separating them out to decide independently. Systematic investments, recurring deposits, EMIs and gold schemes work for this reason. In contrast, make spending decisions a separate and conscious one. When gains and incomes are separated and highlighted, they bring a great joy that we see the gain almost as if it is free money.When losses and expenses are separated and highlighted, we are much more unhappy and unwilling to make decisions. Mentally we account for them very differently.

Therefore, the need to disguise the investments so they do not come up as specific decisions to make, and to separate the spending so it becomes a tough decision to make.The credit card disguises the spending easily and therefore is a harmful tool in the hands of a compulsive shopper.

We can use mental accounting to our advantage, if we decide to make investing a habit and spending a conscious decision.We may not be able to modify our behaviour much, but we can set up tricks to sidestep the limitations.