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Money Mistakes

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Everyone makes mistakes at times, and this is no different when we are dealing with money. We may be vaguely aware that we're making a mistake when it happens, or it may be entirely ignorance. The science of behavioral economics is showing just how subtle these things can be. Consider the following two common mistakes - are you making them?

Mental Accounting

Mental accounting is a term used by researchers in the field of behavioral economics. It refers to how we treat money from different sources differently. If you work hard to save $2,000, you might be very careful in how you spend it, for example, while a $2,000 tax refund - which seems like a lottery win - might be treated much more frivolously. The amount is the same, and you're free to use it any way you choose, but a "windfall" is typically treated differently from earned income by most people.

I saw extreme examples of this when I dealt blackjack. Players had a mental category they called "house money," which was the profit that they had made, or the amount that they were ahead. A woman might be very cautious betting with her "own" $200 bankroll, but once she had $600 of winnings in front of her, she would start betting more and playing more carelessly. "Oh, I'm just playing with "house money" she would explain.

The reality is that once a man wins the money in the first place, it's all his money - the same as any other money he has. He can walk out that door and do anything he wants with it. A typical gambler might stop before he ever lost $600 of "his own" money, but losing the "house money" is somehow a different story, with a predictable ending. With common sense he could choose to lose even $500 of his $600 win and still leave with a profit, but more often, he will lose the $600 AND whatever bankroll he brought.

Think this is not a problem of yours? Hmm... What if you won $1,000 on a lottery ticket, or got a $1,000 bonus at work? Would you take your windfall and put it into your retirement account or your child's college account? Would you really treat such money the same as if you worked weekends to make an extra thousand dollars? "Metal accounting" is an easy money mistake to make.

Mistake - Integrating Losses

Here's another tough one to avoid making. Notice how when you buy that new car, an extra $400 for a better car stereo doesn't seem like much? You are spending $22,000 for a car, making $400 seem like "just a little extra" - and that's why that salesman will push these extras. Now consider that if it isn't too much for stereo, why did it seem like a lot to buy one for your previous vehicle? In fact, perhaps just the day before you might have thought $200 was too much to spend.

The psychology here is about making large purchases or taking large losses on something. It s also another classic habit you see in gamblers. A man thinks $100 is too much to lose at the start of the night, but once he is suckered into losing $2,000, it seems easier to bet that last $100 on one hand of blackjack. The phenomenon isn't limited to gamblers or new car buyers, though.

Let's suppose you're having a new house built for your family. The builder has you excited about the latest refrigerator, which he'll include for only $3,000 more. Now, that same refrigerator might have been worth just $1,800 maximum to you one month earlier. You might even buy one for just $1,500 if you wait until you move into the house. However, because you're spending (or borrowing) $300,000 to have a home built, $3,000 just doesn't seem like so much.

To avoid making this money mistake you have to mentally step outside of the situation and ask yourself if the proposed expenditure is one you would have felt good with a week ago. Consider any other options you have, and finally, just wait a bit. A few weeks later - after a large purchase - you might be in a more rational state of mind to decide what something is worth to you. It is tough to avoid these money mistakes, but it is worth it.

You'll find more money mistakes covered on the page Ten Financial Mistakes.



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