Get richer by avoiding this money mistake

Mental accounting is one such money mistake even smart people commit. Understanding this mistake and avoiding this could make you richer.

Behavioural finance experts say that mental accounting works this way: Let us say you have bought Rs 200 ticket to a movie. When you show up at the entrance of the theatre and realise you have lost your ticket, do you buy another ticket?

If you were like most people, you would probably think twice. You may still drop down the money, but you will now feel that you paid Rs 400 for Rs 200 ticket.

But let's construct the scenario differently.

Let's say you hadn't bought the ticket yet, and you show up at the entrance to buy your ticket.

And unfortunately, you realise you've lost Rs 200 in cash since you walked from the parking place.

But fortunately, you still have enough in your wallet to cover the cost of the ticket. Do you buy the ticket?

Again, if you are like most people, you may feel upset about the lost money, but it probably won't affect your decision to buy the ticket.

Why?

Behavioural finance experts conducted similar experiments. They found that 46 per cent of those who lost the ticket were willing to buy a replacement ticket.

On the other side 88 per cent of those who lost an equivalent amount of cash were willing to buy a ticket.

Both scenarios are a loss of Rs 200. However, in the second scenario you separate the loss of Rs 200 from the purchasing of the ticket.

In the first you consider the cost of the movie as a total of Rs 400 and baulk at the high cost.

It is because of the psychological phenomenon known as mental accounting.

One of the fundamental concepts in economics says that wealth in general and money in particular, should be fungible.

Fungibility, in a nutshell, means that Rs 100 in lottery winning, Rs 100 in salary and Rs 100 tax refund should have the same significance and value to you since each Rs 100 has the same purchasing power in the market.

But do you treat them in a similar way?

Mental accounting has enormous consequences in your daily life. It affects how you spend money and how you save. It influences how you deal with losses and windfall gains.

How does mental accounting affect you?

* The source of the money affects how it is spent
* You tend to dine lavishly with the 'gift meal vouchers' given by your company. But you will be dining consciously if you were paying out of your salary
* You are most likely to spend more with credit cards than with cash
* You may consider tax refund as 'free money'. In actual terms it is your own money. You will not spend tax refunds, birthday gift money or lottery winnings on essential things like utility bills, school fees, paying off your credit card debt. But you will be more than happy to spend the same money on discretionary items such as vacations or a trendy mobile phone

Don't be a victim of 'relative cost'

Assume you are going to a super market to buy a laptop. The price is Rs 40,000. But you get to know that there is another branch of the supermarket, ten-minute walk away, in which the same laptop is sold for Rs 39,950.

Will you walk down to the other branch to save Rs 50?

Let us say instead of buying a laptop you have planned to buy a memory card. The price at the supermarket is Rs 100 and at the other branch the price is Rs 50.

Where will you buy the card?

Most of us will make a trip to the other branch for the memory card but not for the laptop. Because we think that the Rs 50 saved on Rs 100 item is better than the same amount saved on an item worth Rs 40,000.

But in both cases the situation is same. You save Rs 50 by making 10 minutes walk to the other branch.

Remember that money is money.

Rs 50 saved on Rs 40,000 laptop is not less money than Rs 50 saved on Rs 100 memory card.

How to face mental accounting and spend consciously?

* You can use mental accounting to your advantage by spending money out of your salary. Immediately invest the 'free money' like tax refunds, gifted money or any other windfall gains
* Imagine that all income is earned income
* Use the free meal vouchers and other gift vouchers to buy essential items
* Pretend you don't have a credit card. I am not telling you not to use credit cards. I am saying you should stop and think: would I buy this if I were using cash?


A successful practical strategy

You can have two bank accounts. One for the purpose of savings and the other one for spending.

Every month you need to set aside some amount for expenses as per your budget or previous experience. That amount you need to transfer to your spending account.

Keep the balance amount in your savings account.

You need to meet all your expenses including your credit card payment from the spending account. You should not spend from your savings account.

In between, if you receive any cash gifts or windfall gains, deposit them in your savings account.

If you receive gift vouchers, then transfer the money equivalent of that voucher from your spending account to your saving account.

This will help you not to exceed your spending limit when you receive the gift voucher. As a result you will not use it lavishly and use it only on pre-planned things.

When it comes to money your mind unconsciously plays this trick of mental accounting. You have understood that today. So hereafter, you can avoid this mistake and you become richer day by day.

Stock basics: All you want to know about PE ratio

Commonly called the PE ratio (or just PE), it is often used in investment analysis. However, investors sometimes fail to understand the factors that determine it and its limitations

What is it?

The PE ratio is calculated by dividing a company's share price by its earnings per share (EPS). So, if we assume that a company's share price is Rs 200 and its EPS is Rs 10, the PE of the stock will be 20 (Rs 200 divided by Rs 10).

Note that the EPS of a company can be calculated in different ways, resulting in more than one PE for the same stock.

If the EPS for the last 12 months (four quarters) is used, the resulting PE is called trailing-twelve-month (TTM) PE.

If the EPS for the next twelve months is forecasted and used in calculation, the resulting PE is called forward PE.

For a company that operates in a cyclical industry, the EPS considered is the average EPS over the complete cycle, and it is called seasonally adjusted PE.

Interpreting the ratio

As the calculation of the ratio suggests, the PE multiple implies the amount an investor is paying for each rupee of the company's EPS. So, if the PE of a stock is, say, 20, the investors are paying Rs 20 for each rupee of the company's EPS.

The higher the PE ratio of a stock, the more investors are paying for that stock, and vice-versa.

That explains why it is said that a high or a low PE implies whether the stock is expensive or cheap, respectively.

How much should you pay?

The PE of a stock should ideally depend on some factors. The first is growth. Growth is directly proportional to PE.

The higher the growth, the higher will be the PE that the stock should command.

The second factor is risk, and it is inversely related to PE. So, a stock should have a low PE if the risk associated with it is high.

A company's dividend policy also determines its PE.

The greater the proportion of profit given as dividends, the higher will be the PE.

As shares do not always trade at a price based on their fundamentals, a stock's existing PE could differ from the one that should be based on the factors determining it.

So, pay for a stock based on these determinants.


The limitations

With various accounting standards available, a company's EPS figure will depend on which method it follows.

In other words, the PE ratio gets influenced by the accounting norms.

Also, when a company's earnings are negative, assigning a value to its stock using PE is not feasible.