A buck is a buck—right?

By Don Kuehn

If you saw a newspaper ad for a small appliance at your local store for $19.95 and saw the same thing on sale at a large national chain store for $11.95, would you drive an extra 20 minutes to get it at the lower price?

Two-thirds of the people in a national survey by Northwestern Mutual said they would make the trip.

But three-fourths of the same people said they would not drive 20 minutes across town to buy a television for $242 if the local store had the same thing for $250.

In each case, 20 minutes nets a savings of $8 (less the cost of gasoline). That $8 would buy the same amount of groceries, pay the same share of your credit card bill or go equally toward a new pair of shoes, but it seems bigger in relation to the appliance than it does to the TV set.

The people taking the survey fell victim to "mental accounting," a false belief that some dollars are worth more than others. It doesn't matter how sophisticated the respondents are (these were all doctors, lawyers and accountants). This is a trait shared by almost all of us.

According to Tom Gilovich, a Cornell University psychologist who assisted in the Northwestern Mutual survey, there are three key impediments, or "blind spots," that keep us from making good financial decisions:

• Framing is basing decisions on how a situation is presented. For example, the whole notion of budgeting and saving—ideas that many people shrink from—become more attractive when recast in terms of the nest-egg we can accumulate rather than the sacrifices we would have to make in the near term.

That's one reason automatic payroll deductions are so effective. Whether for savings bonds or to fund an IRA or 403(b) account, we don't miss and can't spend money that doesn't pass through our hands. But we can watch our investment grow every time we get a statement.

In the survey, one cohort was asked: "Could you comfortably save 20 percent of your household's income at this point in your life?" About half said they could not.

Another group was asked: "Could you live comfortably on 80 percent of your household income today?" and more than 70 percent said they could.

Now, those of you who are paying attention will immediately recognize that the two questions produce exactly the same result, but the respondents—well-educated professionals earning more than $75,000 per year—gave markedly different answers. It's all in how the question is framed.

• Loss aversion is the notion that losing money hurts more than the satisfaction we get in achieving a financial gain. That's why so many of us will hang on to an underperforming investment. We've been sold a bill of goods: that if we sell the bad mutual fund or stock, our losses become "real." Until then we get away with calling them "paper losses."

Selling a bad investment can, in fact, be a good financial move if the loss can be claimed against other gains on your tax return, or if it "stops the bleeding" of further losses. There is also the potential of turning your remaining balance into a significant gain by investing in other assets.

• Mental accounting is treating money differently depending on how we got it. Many people will fritter away a salary increase, birthday gift, bonus or tax refund because it seems like "found money."

Tales of lottery winners blowing their windfall within a year are legion. Anecdotes about irresponsible spending by people who inherit large sums haunt those of us who have taken time to plan for the disposition of our estates when we die.

Rather than using "found money" to make their lives, their retirements or their children's lives better, people use mental accounting as an excuse for profligate spending because "it just dropped into my lap."

The same blind spot pops up when we overspend on a credit card as compared to cash. Hey, that's money you are charging on that card. Twenty bucks on plastic has the same value as that 20-dollar bill in your wallet.

Are these blind spots so ingrained in our psyches that we can't do anything about them? Of course not. Awareness of the way you think about finances can pave the way to making smarter use of your money.