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Consider this situation : The latest SRK block buster has been released. Like so many others, you too are eager to see the movie. You buy a ticket a Rs.250 ticket in advance booking a day earlier. The next day, you eagerly make your way to the multiplex. At the multiplex, you realize to your horror that you have misplaced the ticket. You can't find it anywhere. Did the ticket remain in your shirt pocket yesterday and would it by now have got thoroughly washed in your washing machine along with the shirt? Can't figure out. You glance at the ticket window. Some tickets are still available in current booking. But, that will be another Rs.250. You stop for a minute to ponder whether you should go ahead and buy another ticket. A feeling of regret instantly comes in : I'm paying Rs.500 for a Rs.250 ticket! You are caught in two minds....
Consider a slightly different situation : you didn't buy the ticket in advance, you landed up at the multiplex to buy the ticket in current booking. You opened your wallet confidently, knowing that you had Rs.700 in it - you counted it last night. To your dismay, you find that the wallet holds only Rs. 450 now - Rs. 250 has inexplicably vanished! Could your maid have helped herself to the money when she cleaned your room this morning? You don't know. Your thoughts are rudely interrupted by the ticket salesman who shouts "Next" - your turn has come in the ticket line. Will you promptly pull out Rs. 250 from your wallet and buy the ticket or cancel the movie plan because you lost Rs.250 - which was the amount you intended to spend on the movie?
We are all different human beings, we think differently. Your response to both situations may be different from others. Research suggests that 46% of respondents who were posed this question said they would hesitate to buy a second movie ticket when they lost the first one, but 88% of the same respondents confirmed that the loss of money from the wallet would not impact their decision to buy a movie ticket, even if the amount lost was exactly the same as the cost of the ticket.
Why is it that 250 rupees spent on a "second" movie ticket hurts us so much more than 250 rupees lost from our wallet? After all, its your money - and one way or another, you became poorer by Rs.250. Why do you react differently in the two circumstances when in reality, both situations caused you the same loss?
What is mental accounting?
The answer to this lies in what behavioural finance specialists call "Mental Accounting". The human mind instinctively compartmentalizes incomes, expenses, assets and liabilities - it creates different accounts for different expenses. For the 46% who hesitated to buy a "second" movie ticket, in their mind, the movie ticket account had already got extinguished with the first purchase. Buying a second ticket would mean busting that account - which is why they hesitated. After hesitating briefly, the mind will then weigh the urge to watch the SRK movie anyway against the regret of busting the movie ticket account. Whichever sentiment prevails, is what will influence the final decision. On the other hand, the loss of money from the wallet did not go out of the mind's movie ticket account. This loss is not seen by the mind as meaning that you are paying Rs.500 for a Rs.250 movie ticket. You therefore go ahead and buy the movie ticket anyway. The mind does not treat all money as fungible, even though it is your money anyway - it compartmentalizes it instinctively.
How does this impact investing behaviour of your clients?
Have you noticed that a client who normally opts for very cautious investments from his monthly savings, surprises you with a rare aggression when he talks about investing an unexpectedly large annual bonus into equity funds? Have you seen your most cautious investors willing to become more adventurous with windfall stock options that they have realized? And, have you noticed that the adventurous streak is confined to only that windfall amount, while the same cautious approach continues with the regular monthly savings?
Its not just expenses - we keep mental accounts for expenses, income, assets and liabilities. This, in a way, is the foundation for financial planning. Financial planning is nothing but putting together a series of mental accounts - one for each goal, and tracking progress of each mental account. It is because the human mind instinctively creates accounts anyway, that you find that when you segregate a client's portfolio into different accounts, his behaviour towards each component suddenly changes. Lets explain this a bit.
Lets say a client has a Rs. 20 lakh portfolio for which he receives monthly updates on performance from his advisor. He views this as an overall portfolio and takes buy / sell / hold decisions on each holding based on relative merits. Now, if another advisor were to talk to him about his goals and after discussions, agree that the same portfolio will be carved out into 5 different buckets - 2 for childrens' higher education (the client has 2 kids), 2 for their marriage and 1 for the client's retirement, and if the new advisor were to present periodic status reports for each of the 5 accounts, the client would view the same portfolio very differently. For instance, in case of an urgent requirement of funds, he would not want to touch the portfolios dedicated for his children, but would more willingly dip into his retirement fund. Even if a fund expert were to try and reason with him that a holding in the kids account ought to be redeemed for this purpose as it is the weakest performer in the overall portfolio, and that the funds in his retirement account should be retained as they are strong performers, the client may be much less willing now to look at the portfolio in this holistic manner - since the compartmentalization has been done. The emotion of not wanting to touch kids money would usually overpower the logic of exiting the weakest fund in the overall portfolio to raise cash.
Use mental accounting effectively to create happy investors
Advisors who adopt a goal based approach are able to get clients to stay invested for longer periods, especially during times of market volatility. Why does this happen? Because there are now two emotions that are in conflict in a client's mind. When investments are not slotted into goals, they are pure investments - which need to deliver a certain return to remain in the portfolio. When markets start falling, fear takes over and investors choose to redeem as fear is the primary emotion. On the other hand, when the same investments are slotted into say a child's higher education account which is due to be utilized 8 years from now, the client is suddenly a lot more patient with these investments during a market fall. The emotion of not wanting to destabilize his child's account is one possible cause. The comfort that the money is not needed for another 8 years anyway is another cause. When you have alternate emotions that can fight the fear, you have a better chance that the client will stick with the plan, through choppy times.
Goal based planning as the basis of your investment advice has many merits - apart from the merits of a financial planning proposition, there is one more : humans anyway instinctively compartmentalize money. You are only putting an organized structure to a thought process they anyway embrace sub-consciously. Make the sub-conscious effort into an organized conscious one, and you are on your way to creating many happy investors.
All content in MasterMind is created by Wealth Forum and should not be construed as an opinion of Sundaram Mutual Fund.
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MasterMind is a joint initiative between Sundaram Mutual and Wealth Forum, in which we offer insights into how you can become a more effective advisor to your clients, by understanding them better, understanding how they think, understanding how they take financial decisions. This gateway into your clients' minds we believe will help you relate better to them, communicate more effectively with them and thus serve them better. Mastering your client's mind is your gateway to becoming a more successful advisor. Its not for nothing that they say, "Its all in the mind!"