Posted by Lending Club :: February 13, 2009 @ 6:07 am

If you were to reduce all of my philosophies on personal finance down to a single principle, I suspect that performing cost-benefit analyses would be the result. Applying this method to all that you do will help to get your finances back on track.

Cost-benefit analysis simply means determining whether a choice or course of action is worth it to you. At times this analysis is extremely straightforward and at others it takes some work. The final comparison is the same, but the difference between the two cases is similar to a basic math problem and a word problem from math class. In the latter case, the first step is converting the circumstances from words into the equations and expressions that can then use basic math to be solved. And you thought you'd never use those grade school skills again!

A simple example of a cost-benefit analysis is whether you should buy a name brand or generic product. In many cases, you might not notice much difference (or any at all) between the two products and would decide to buy generic to save money. If you do notice a big difference, then the premium price for the branded product may be worth it. You can imagine how you might come to a different conclusion as the difference between the two prices or products varied. This shows how you might react differently to changes in the cost (the difference in the two prices) or the benefit (the perceived difference between the product) as both come into play in a cost-benefit analysis.

It's easy to see how a more detailed analysis can result from even this simple case. Suppose you had to drive to another store to buy the generic product. Now, the cost of your time, gasoline, and perhaps even wear and tear on your car could be added to the consideration. More complicated questions can be analyzed in a similar way. From a pure cost perspective, you might choose to always prepare your own food rather than eating out. But considering the joy you get when you do go out, the time it takes to plan, buy, and prepare food at home, and even your aptitude in the kitchen may adjust your final conclusion. We often perform much of this analysis subconsciously, but it all still factors into our decisions. By consciously recognizing these factors, we can make better, more informed decisions.

In my opinion, nearly every financial decision boils down to a cost-benefit analysis, which is why I consider it my guiding principle in personal finance. Carefully answering the question “Which choice gives me the best combination of low cost and high benefit?” will help to make financial decisions much easier. There will be times when insufficient information is available to make the best decision, but with practice you'll quickly learn to assess even those situations effectively.

Do you perform a cost-benefit analysis to help you make financial decisions?