Personal Finance is Not Always About Math

by Ace on June 30, 2010

Numbers are absolute. They’re cold and predictable. But humans aren’t. You can’t treat personal finances like a math problem. Scribbling a bunch of equations on a piece of paper won’t give you a solution. Personal finance is so much more complicated than that because it’s personal.

We use personal finance heuristics to simplify things. Heuristics are simple rules that reduce the complexity of a problem. For example: don’t spend more than 37% of your pre-tax income on housing. They are great because they can help you make sense of your finances. But you have to be careful, because sometimes these great tools make us lose track of the personal element in personal finances.

Three Areas Heuristics Hurt Us

Here are three areas where heuristics can ultimately lead to pitfalls.

Heuristics in Your Budget

Misconception: You need to use guidelines to create a budget.

Rather than using guidelines that other people give you (like spend less than 37% on housing, save at least 15%), you need to track your spending. Once you track your spending, then you will understand how much you spend in each of the different categories of your budget. Then, you can use this information to focus on the problem areas.

What’s a problem area? A problem area is where you are spending more on something than it’s worth to you. For example if you don’t care where you live, and you don’t mind living in a small minimalist house, it probably doesn’t make sense for housing to represent 50% of your budget.

Heuristics in Your Net worth

Misconception: Your net worth is a direct indicator of your financial health.

Net worth, while important, is not a direct representation of how well you’re doing financially. Our infatuation with numbers causes us to place too much value in the number itself.

Rather than focusing so much on minor details of your net worth calculation, just pick something and stick to it. Net worths are great because they expose trends. Do you find that money is constantly going from savings to checking? Are your contributions to investments or savings decreasing steadily month to month? These are the type of macro trends that your net worth calculation can help you find. Bottom line is that you shouldn’t assume that your net worth represents your wealth.

Heuristics in Your Debt

Misconception: You always pay down the highest APR debt obligation because it makes the most sense mathematically.

Although it may make the most sense mathematically, for many people it doesn’t make the most sense. A bigger factor of whether or not we reach our financial goals is whether we follow through with our plan. Rather than doing what makes the most sense mathematically, think personally. What will help you stick to your plan? Consider all your options when thinking about which debt to pay down.

Heuristics as a Tool

Don’t get me wrong. I love heuristics. Without them we would have a difficult time dealing with many of the complex issues life and personal finances throw at us. It’s just important to be aware that there’s more to personal finances than following these rules blindly. Before using a heuristic, verify it makes sense. Don’t use heuristics to avoid thinking about the crux of the problem. Remember numbers are cold, humans are not.

(Photo credit: aussiegall)

Update: This post was included in the Carnival of Personal Finance #264 over at My Journey to Millions