Denomination Effect


Denomination Effect
The denomination effect is a theoretical form of cognitive bias relating to currency, whereby people are less likely to spend larger bills than their equivalent value in smaller bills. It was proposed by Priya Raghubir and Joydeep Srivastava in their 2009 paper “Denomination Effect”.
In an experiment conducted by Raghubir and Srivastava, university students were given a dollar, either in quarters or as a single dollar bill. The students were then given the option to either save the money they had been given or to spend it on candy. Consistent with the theory, the students given the quarters were more likely to spend the money they were given.
http://en.wikipedia.org/wiki/Denomination_effect

It is basically a tendency to spend lower denominated money easily and quickly without any hesitation or negative feel, than spending higher denominated money.
That is, we may find it easier to spend five Rs.10 notes, rather than take a Rs.50 note to spend.

Denomination Effect examples
1. Spending coins than higher denomination notes. We always want to keep Rs.100 or Rs.500 in our wallet and spend lower denominations first. We have heard people say, ‘if I exchange it, I will spend soon’.
2. A product that is priced Rs.49.99 and Rs.49.00 and Rs.50.00 does not seem to have any difference
3. When we get a tax return or bonus as Rs.25245.00 – we tend to spend Rs.245 and save Rs.25000
4. Thinking if the price is lower, the product may be cheaper – yes, it could be, but, is it value for money?

Overcoming Denomination Effect
1. Trying to be rational with money is the basic thing to practice
2. Look at the real value of the money however small it is
3. Remembering what our parents taught us – several drops together make a stream – Smaller denominations make one large denomination

My experience with Denomination Effect
During my early days of investing, I have considered stocks which are in two digits are cheaper and especially if it is associated with a brand name, I bought them without much deeper analysis. I preferred to buy 100 shares of Rs.15 rather than buying one Rs.1500 share.
As I learnt investing and stocks and valuations, I understood that the price does not signify anything, instead only the value underneath the business is.

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Filed under Behavioural Finance

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