The human mind has a limited capacity to deal with numbers and
statistics. Therefore we tend to use shortcuts to assimilate and
act on massive amounts of information.

We look for patterns and generalities to allow us to justify
conclusions and make decisions. Often these patterns are not
reliable or the generalities do not apply to the situation we are
analyzing. Our mental shortcuts often lead to unjustifiable biases,
which lead to decision errors.

With the huge amount of financial information now available, it
is no surprise that many of these biases and errors affect our
personal finances.

To complicate matters further, almost all advertising in some
way mentions or infers that we will be better off financially if we
succumb to the enticements of the advertiser. Even some news
reports contain misleading or biased information.

Consider two examples of how our mental accounting can lead to
errors in handling money. You go to a store to look for a CD
player. The store’s price for the player you want is $100. You
remember seeing that a store a mile away advertised the same player
for $75. Do you drive the extra mile to save $25?

Same scenario, but you are buying a home entertainment center.
The first store has the entertainment center priced at $2,700,
while the second store advertised the same item at $2,675. Both
stores offer comparable service, warranty, etc. Do you go to the
other store?

Both situations offer the same basic question: would you go a
mile to save $25? Research shows most people would drive the extra
mile to save $25 on the CD player, but not for the entertainment
center. The reason is that the savings on the entertainment center
is a much smaller percentage of the price, so the savings is
mentally devalued.

Another example involves gambling. We know the odds are in
stacked in their favor, but the odds alone do not fully explain the
earnings of the casinos. Most people are more conservative with
their initial bets; but if you win, then you are playing with the
“house’s money.”

In other words, gambling winnings are not “real money,” so we
continue to gamble until we are once again “even, or slightly
ahead.”

Never mind all the money we blew getting back to that point.

Similarly, those who receive financial windfalls tend to
undervalue the money. Windfalls come in many forms: a gift or
inheritance, a lawsuit, a divorce settlement or even a winning
lotto ticket. There is an inclination for this money to be used on
an expensive automobile, new furniture, or some luxury expenditure
outside of your normal budget.

In the above examples we have mentally devalued money, making it
easier to spend. Sometimes we put too much value on a particular
use of money. Home mortgages are a prime example. Because of the
emotional attachment to our homes, we have a tendency to want to
pay off the mortgage. The mental image of “burning the mortgage”
enhances the attractiveness of making extra payments.

If you miss saving $25 on the purchase of an entertainment
center, the dollars lost will not have much affect on your
finances. But in making decisions with large sums of money, such
errors can mean a serious blow to your wealth.

So how can you avoid making mental accounting errors with your
money? The first step is to develop a financial plan. You’ll need
lots of financial education, and lots of introspection about how
you want to live. Too often, financial plans are developed using
some chart or formula found in an investment company’s publication
or Web site.

Using these guides will get you the results the investment
company wants-but could be far from the financial plan you truly
desire.

Send questions to dan@cookfinancial.net or to Cook Financial
Associates, 240 Wilcox St., Castle Rock, CO 80104.

Daniel Cook is a certified financial planner licensee with an
independent planning practice in Castle Rock.