The concept of mental accounting was developed by Richard Thaler. The concept underlines the fact that humans allocate separate values to the same sum of money, depending on the source from which it is acquired. Ideally, ₹100 earned either from gambling, lottery, salary, or gift should have the same purchasing power and should not be distinguished. However, investigations show that this is not the case for individuals. People psychologically divide their money into various accounts, assigning each account a unique meaning.
It is also evident when you receive money from your salary; you tend to spend it very cautiously as it's your hard-earned money. Whereas when you receive money as a gift, you tend to spend it lavishly as you treat it without any effort.
Parekh advises the readers to refrain from using credit cards and treat all money equally. On the other hand, he also advises everyone to analyze themselves. If you are a spendthrift (a person who spends a lot of money carelessly), it's better to do mental accounting in order to have financial discipline.
Now how to know that? Parikh shows an interesting test. Let's assume you want to buy an expensive suit. In the first scenario, you won the ₹10,000 lotteries. In the second instance, ₹10,000 was kept and forgotten in your almirah. Which one would you use? If your answer is the first one, i.e. lottery, you are prone to mental accounting.
In order to save yourself from financial distress, you should:
- Always pay cash and never use credit cards. This will make you aware about the cash outflows.
- Be alert about your purchases. For example, if you are buying a car, be very careful of the associated non-essential expenses like car accessories, extended warranty, etc., which might not be that useful.
- Be patient whenever you get a windfall gain. Don’t hurry and spend all of it. Spend a month or two planning for it and this way you are most likely to end up saving.
- Treat all income as earnings and do not treat them separately.