Mental Accounting: Money is fungible. That is Rs. 100 is equal to Rs. 100 only, not more nor less. However we human beings accord different values to the same amount of money depending on how the money is earned, the effort taken to earn, the quantum of money in consideration and the source of the money. To give you an example; Rs.5000 earned as salary has more value than Rs. 5000 earned in winning a lottery ticket. We are more likely to splurge on the earnings from lottery than on earnings from salary. We tend to separate Rs. 5000 in to two different mental accounts. Serious and hard work mental account for salary and free money mental account for the lottery. This mental accounting is responsible for a host of mistakes we make in our spending and investment decisions. Being aware of this will make us better and wiser decision makers.
In the investment world lets understand the mental accounting biases with refer-ence to interest and dividends. We make investments to earn a return and that could be by way of interest or dividends. If we make fixed income investments we get an interest which we know in advance. We treat this in a mental account of planned earnings and treat it with respect. However when we make investments in equities our returns are from dividends. Dividends are never fixed from before and are subject to the company’s performance. Hence when we are rewarded with divi-dend there is a different type of joy. This virtue of the unknown makes us treat this earning as free money and we put it in a mental account of free money and we are likely to splurge on the same. Although our interest and dividends are of the same quantum we would put them in different mental accounts. Interest would be earned and dividend would be gained.
If you do not understand your own biases then in a competitive market there are others who would exploit it to their advantage. Mutual Fund Industry does it best to exploit investors mental accounting bias by giving the dividend option. Lets under-stand the structure of a mutual fund. Investors pool in their resources and the same are managed by the asset management company. The monies entrusted are in-vested in the market and according to the prices of these investments, everyday the fund publishes its NAV.
Lets take a hypothetical example: A fund collects Rs. 10 crores and issues one crore units at Rs. 10 each. There are 1 lac investors holding 100 units of Rs. 10 each. Now this Rs.10 crores is invested in the market and with the prices of investments rising the NAV goes to Rs.15. Now this money belongs to the investors. The investor held 100 units of Rs. 10 each and had paid Rs. 1000. Now his investment fetches Rs. 1500. Now the mutual fund gives a dividend of Rs. 2 per share. This money will come directly from the corpus of the fund which at present is Rs. 15 crores. To pay a dividend of Rs.2 per share to one lac investors holding 100 units each will come to Rs.2 crores. So after paying the dividend the NAV will go down to Rs. 13 crores and the unit price will quote at Rs.13. The unit holders have been paid back their own money and they are happy. Mental Accounting is at work. Dividends are considered free money and hence the joy. Dividend from a mutual fund is very different than a dividend from a company. They are not representative although they seem to be. The company has a business, it earns profit and from the said profit, a part is distributed to shareholders as dividend and the rest is ploughed back. A mutual fund manages the money and returns a part of it as dividend and the corpus goes down. Although both seem the same they both are very different.
However if one is an investor in a debt mutual fund and is getting dividend then it is a double whammy. When his own money is given to him as dividend the fund is re-quired to pay a dividend distribution tax of 28%. It is surprising that fund houses follow such tax inefficient practices that are against investor interest. However Eq-uity funds are not liable to pay the dividend distribution tax.
Investors decide the dividend they need: Parag Parikh Flexi Cap Fund has no dividend option in their scheme. The goal is to encourage investors think and act long term. The investor can decide the quantum of the dividend he wants and can redeem an equivalent amount of units. This way investors will be thrifty in dealing with their finances making them self disciplined. Investors will not fall in to the mental accounting trap and will redeem only that what their need is. Investors need to inculcate such discipline with their investments. In the long run they will benefit.
