We often tend to splurge money we receive as a gift, and spend judiciously when it is earned. But money is just a tool and is not supposed to have labels attached to it

I met a family travelling abroad for a month, and the cost of their trip is coming to Rs 9 lakh. They told me that they had sold some property and invested the money, and this was the interest on the amount they had invested (after paying tax).

While it is completely their business, and I am certainly glad to see people use their money to enjoy their life, I instantly spotted the behavioural bias we refer to as mental accounting. This is when we assign subjective value to our money. We perceive it differently depending on the source and ease at which it came into our possession.Before I define it in detail, let me share a few examples.

Economist Richard Thaler narrates this story to describe mental accounting. A couple went on a fishing trip and caught some salmon. They packed the fish and sent it home on an airline, but the package was lost in transit. So. they received $300 from the airline, out of which they splurged $225 on a dinner. They had never spent that much at a restaurant before.

Money is not supposed to have labels attached to it. Yet the couple behaved the way they did because in their mind, the $300 was a “windfall gain”. The extravagant dinner would not have occurred had each received an increment of $150.

Psychologist Hal Arkes narrated a story of employees of a firm taken to the Bahamas on a retreat where each was given a cash bonus of $100. Almost all of them headed to the casino. What was interesting was that up to $100, they had no qualms betting. The moment it crossed that threshold, they got more cautious and slowed down or stopped altogether, because they felt they were playing with their “own” money rather than the “free” money. Ironical, is it not? The $100 was their “own” money too, it is just that it was handed to them and never came out of their own pocket.

In the book Why Smart People Make Big Money Mistakes & How to Correct Them, the authors talk about an experiment conducted with 24 students at the Harvard University.

The students received $25 each as part of a research project and could spend as much as they wanted at a particular store. The unspent amount (from $25) would be sent to them by cheque.

All were told that the research was partially funded by tuition dollars, but half of them were told that it was a bonus, while the other half was told that it was a rebate. That apparently small difference dramatically affected how students handled their windfall.

Of those who considered it a bonus, 84 per cent of them spent some or all of the amount. Of those that viewed it as a rebate, only 21 per cent spent any money at all.

What Is Mental Accounting?

Money is a tool. It is not good or bad. It is neutral and objective. There is no “easy money” either, but we end up viewing it in that way depending on the source and the label we assign to it.

Imagine yourself at the receiving end group of a windfall, let’s say, Rs 10 lakh. If you won a lottery, would you not view it differently than if it had been an annual bonus? The chances of you splurging in the first instance are much higher, though the amount is identical in both instances. That is because when we earn the money, we are more likely to put it to practical uses. If it was won, found, or given to us, we are more likely to spend it for enjoyment.

Wedding gift, birthday gift, graduation gift, Diwali gift, winning a lottery, inheritance… we don’t think of them as “earned”, so we assign a different value to it. We are more frivolous with it when it comes to spending. Then comes the tax refund and the bonus; where we may be a little more cautious, but still get carried away. But the way we behave with our salary or an increment will certainly be different.

How we view money impacts how we put it to use.

What Must You Do?

During my recent visit to Kashmir, I met a lady who told me how she received an unexpected inheritance from her father when he passed away. She was completely unaware that he had that amount in savings. But instead of splurging it, she purchased land, built a home, and now she and her husband run a homestay. This was many years ago, and it is now worth a tidy sum.

This story stuck in my head, because in October, a colleague based in Chicago, Madeline Hume, wrote about an unexpected inheritance of about $20,000 from a relative. The money came from a lump sum invested in an annuity.

I really liked the way she explained how she tackled it. I borrowed some of her pointers and built on it.

• Address emotional needs first else it could leave you devastated. Death is hard and irrevocably shapes our outlook. It could be euphoric—imagine winning a lottery. A friend who recently got married told me that he got a huge amount by way of cash, and since wedding gifts are tax free, he is ecstatic. Accept the grief or celebrate the joy but address the emotion first.
• If it is an inheritance or a gift, intent should take precedence. I asked my friend if any of the gifts were given with intent, such as, “money to buy a refrigerator” or “money to buy a microwave”. Or, has the giver spelled out wishes for how the money should be spent? Some bequests carry a directive to the person receiving it. In Madeline’s case, there was none.
• Address any debt. If there are any loans hanging over your head, clear them; at least partially, if not completely. This is especially when it comes to credit card debt or personal loans, where the interest rate is really high. The financial drain on servicing debt is immense.
• Examine other critical needs that might have been delayed. Have you put off an important surgery or home repair that might stretch your budget? While there might not be a concrete rate of return on such investments, there may be tangible benefits that outweigh the uncertainty.
• Consider near-term goals. What are the big, imminent goals that the inheritance could help meet? Will it help in the downpayment of a home? Or are you really saving for travel?

Alternatively, you can look at multiple options.

• Splurge. Go out for a great meal or take a weekend to drive somewhere. This will depend on the amount you get and how much (%) you want to assign for splurging.
• How much (%) to retire the current debt position.
• How much (%) to be invested.

It is your money. My only advice is not to act impulsively because you will just squander the amount. If you can take a step back and visualise what could be done with that, you might act differently. You can still go ahead and blow it all up. If that is what you want to do, it is fine. The trick is to be aware and question your decisions so that it leads to a well thought-out financial outcome.

By Larissa Fernand, Investment Specialist, Morningstar India