Don't be fooled by the mind
Lets think about these two incidents. You had bought an advance ticket worth Rs 500 to watch a movie. On reaching the multiplex, you realized that the ticket had been lost. Weekend shows are typically expensive and since you didn't want to spend the same amount again, so you gave up the idea of watching the movie and came back home.
In a separate incident, when a friend of your planned to watch a film, he realized he had lost the note he had kept aside to buy the ticket Not agonizing too much over the loss, he took out another Rs 500 note and bought the ticket.
Both the incidents were basically the same. You had lost a Rs 500 ticket and not bought a new one. Your friend had lost Rs 500 and had gone ahead and purchased another ticket. The loss in both the cases was limited to Rs 500. So why did your friend buy another ticket and you didn't ?
This is a situation what economists call "Mental Accounting" or the tendency to categorize different money situations into separate mental accounts.
What are mental accounts ?
The term mental accounting was coined by Richard Thaller, an economist at the University of Chicago. He defines it as "The inclination to categorize and treat money differently, depending on where it comes from, where it is kept and how it is spent."
In the first case, the loss of ticket was attributed to the "ticket loss account", whereas in the latter case, the loss was ascribed to the "money loss account". The human mind tends to add the loss on the "ticket loss account" to the price of a new ticket, that is, Rs 500, and so people in such situations are not reluctant to buy a new ticket. For you, the movie was worth Rs 500, but not worth Rs 1000.
In your friend's case, the mind values the price of a new ticket only at Rs 500, whereas the Rs 500 lost is attributed to the "money lost account". This explains the different reactions to what is essentially the same situation.
Application in daily life
Mental accounting comes into play in various situations in everyday existence, resulting in a monetary loss or an undesired spend. The victim often fails to realize how the mind has tricked him into bearing the loss, content in the belief that he has cut a good deal.
Suppose you plan to buy a costly mobile phone and find one tagged at Rs 15,500 in a retail chain. Just you are ready to flash the credit card and pay for it, a friend calls. He tells you he has bought a similar model for Rs 15,300 from a shop just 3 km away. Will you drive the distance and save Rs 200? Chances are you won't.
Consider another situation. You want to buy a toaster and come across one selling for Rs 1,200. Just as before, you find another gadget selling for Rs 1,000 just 3 km away. Will you rush to save Rs 200 ? Chances are you will. Why does this happen ? On a fundamental level, we are thinking in percentages. If Rs 200 is expressed as a percentage of Rs 15,500, it seems very low in comparison to Rs 200 expressed as a percentage of Rs 1,200. At the end of the day, the saving is all about Rs 200.
Another area where mental accounting foxes us is when we come across a windfall, say a tax refund or bonus. More often than not, the tendency is to spend the money as soon as possible. People consider it 'found' money without realizing that it's their money coming back to them in case of tax refund or deferred salary in case of bonus. A small amount of money that comes to us unexpectedly gets treated lightly and we're more likely to spend it on frivolous things we don't need. Bigger sums that come to us, say, from an inheritance, tend to get treated more seriously and are more likely to be saved.
This is the reason people continue to earn low interest rates on fixed deposits in the bank, while paying a high rate of interest on their credit card debt or a personal loan, instead of breaking the fixed deposit and repaying the debt. Remember that the interest you earn on your fixed deposit will always be lower than the interest you pay on your credit card debt.
The bottom line
We need to realize that the money we earn for various sources is basically the same and we should be careful not to divide it into mental accounts while spending it. So, if you get a good bonus or tax refund, don't spend it by categorizing it as 'found' money.
Also remember that money is fungible. This is the reason you should not let money lie in a fixed deposit while you are paying your credit card balance. It makes more sense to first pay your debt instead of saving money before falling into the trap of 'mental account' foolishness.