Cognitive Bias That Lead to Bad Money Decisions
If managing money were as easy as calculating some numbers and following a spending plan, we would all be great at it. Money is not difficult because of math, psychology confuses us. When it comes to financial decisions, our brains often work against us, but if you recognize these cognitive biases, you can overcome them.
The sunk cost fallacy
If you’ve ever been in a bad relationship that lasted too long, you’ve probably dealt with the sunk-cost delusion . You are investing in something, and as frustrating as it may be, you still hate leaving because that would mean it was all in vain.
There are several subtle ways the sunk-cost fallacy creeps into your day-to-day thinking and often leads to poor shopping decisions . Here are some examples of my own:
- I drove all the way to Best Buy and they didn’t have the phone case I wanted, but I bought one that I didn’t really like (and then replaced it a few weeks later).
- I spent half an hour buying a coat on Amazon. I didn’t find what I was looking for, but felt like I had to buy something to justify my time.
- I bought the wrong paint for my bathroom. Instead of starting over, I just wanted to buy more of the wrong paint for the rest of the room.
Costs can be an issue, but the sunk cost fallacy permeates many important financial decisions. Maybe you stick to a major you hate, just to pay for a degree you never use. Maybe your failed business is turning into a money hole, but instead of cutting losses, you keep spending money on it. These are all costly long-term mistakes. I am using a two step process to handle this. I recognize my trigger first. Then I calculate how much more I will pay if I continue to work.
My trigger is a variation on this statement: “I’ve come this far, I could [insert bad solution here].” Whenever this thought occurs to me, I realize that it is delusion at work. Now I ask, “How much more will I pay if I continue?” The math doesn’t have to be exact, the key is to just stop and think about any additional waste. For example, if I buy more paint, this error rises from $ 25 to $ 100. When you evaluate it this way, your choice becomes more promising.
In fact, simple trigger recognition is the most useful deterrent.
Buyer remorse usually starts with denial, also known as post-purchase rationalization , a form of choice bias . It is a tendency to ignore other views in order to defend a decision you have already made.
This happened to me recently. I spent too much money on a wedding dress that I couldn’t afford , and although I eventually got it back, I first convinced myself that it was a good decision. This is a big, important day, I told myself. I will have this dress forever . I didn’t want to admit that I screwed up my budget.
Post-purchase rationalization, also known as Stockholm Buyer Syndrome, is our brain’s mechanism for reducing cognitive dissonance … the state of discomfort we experience when we hold two or more opposing beliefs at the same time … as if our own internal excuses weren’t “It’s worrisome enough, and we’re also looking for additional evidence to back up our decisions, ignoring facts that contradict them, in a process known as confirmation bias.
You can probably list multiple times when you’ve made spending decisions, but this cognitive bias goes beyond shopping. This can be especially insidious when it comes to tough decisions, and financial decisions are often tricky.
For example, after college, I was intent on paying off my student loan and turned a blind eye to a 401 (k) match suggested by my employer . I orientated myself in my finances, budgeted a debt repayment goal and made a commitment to fulfill it. When my colleague mentioned that I was leaving money on the table, I refused to understand his point of view. I have already made a decision and in my opinion it was the best decision. As a result, I actually left “free” money on the table. It takes time to figure something out, so it’s hard to admit that you’ve got it all wrong. It would have been wiser to listen to my colleague and consider my options, but it was easier to ignore any other facts and tell myself that I had already made the best decision.
The cure is simple: keep an open mind. Of course, this is easier said than done, especially since we think we have a broader outlook than we really do . At the end of the day, you just need to listen to other points of view and facts. As our very own Thorin Klosovski said, “If you’re in a conversation, you’re more likely to hear what the other side is saying if you shut up and listen.”
It is also helpful to have someone to hold you accountable. My parents and my fiance know how to test me in reality. When I told them about the dress, their surprised reaction removed my bias and made me come to terms with the buyer’s remorse. In addition, the defensive reaction can be a trigger. Bias often forces us to immediately defend our decision when someone offers a different point of view. If you can recognize this trigger, it is easy to recognize the bias.
You may have heard about the pegging effect when shopping. This is when you rely too heavily on the first piece of information that you are exposed to and let that information guide your subsequent decisions. You see a $ 19 cheeseburger on a restaurant menu and you think, “$ 19 for a cheeseburger? Of course not! “But then a $ 14 cheeseburger suddenly seems reasonable.
Advertisers obviously take advantage of this phenomenon when they sell you something, but link bias also shows up during negotiations . Let’s say you are interviewing for a job and you are told that the starting salary is $ 35,000, which is much less than you expected. However, that number becomes your anchor, and instead of offering a higher amount, you lower your rate to match that anchor. As a result, you are missing out on your earning potential.
Thus, pegging not only affects how much you spend, but it can also affect how much you earn. Aside from simple admission, the best way to overcome this is to do your own research. If you buy a car and the dealer puts a crazy figure on another car, he tries to tie you up, but that doesn’t matter because you’ve researched the value of that car and already know what to expect.
It’s the same with your salary. If you are researching your industry, job title, and potential company, you need to know what to realistically expect, no matter what is being dictated to you.
After college, I wanted to buy a new car: I put some money aside and then paid for five years at 5% interest. My dad asked, “Why not just save some more and buy a used car in good condition? That way you won’t go into debt. ” I replied, “But everyone goes into debt to buy a car. This is what people do . ” This is the kickstand effect in action.
Rather than making comprehensive, thoughtful decisions that can benefit us more, the advocate effect forces us to simply do what we usually accept as normal. This is one of the reasons for the housing crisis. For years, it has been the norm to get approval for a certain amount of a mortgage, buy a house for about that amount, and then spend years paying it back. Letting the bank decide how much home you can actually afford was okay, so everyone kept doing it and, as a result, bought homes that were well beyond their budget.
I did the same with my retirement savings. For many years I have saved only the very minimum and justified it with the words: “However, none of my friends save anything.” Obviously my friends have nothing to do with my retirement, but this is how the kickstand effect works.
Keeping track of the crowd isn’t always a bad decision. In some cases, paying for a car might make sense (some of our seasoned readers have noted that interest rates are so low that they put their money in instead). Overcoming the winner effect does not mean making the opposite, unconventional solution. It simply means that you do your research and then make the best decision, no matter what everyone else is doing.
When faced with a financial issue , do the math, research all the different scenarios, and then do what works for you.
Status quo bias
Status quo bias is the tendency to favor decisions that don’t make much of a difference in your life or your point of view. And it can work against you when it comes to your finances. For instance:
- Your monthly expenses exceed your income , but you can’t live without cables, restaurants, or ultra-expensive coffee breaks.
- Instead of investing money, you keep it in the same low-interest savings account that you have had for years, and it never grows .
- You can get a cheaper mobile data plan , but you will be comfortable with the same data plan that you have used for years, although it is twice as expensive for the same service than you could get.
We usually prefer the status quo because it is convenient. It is difficult to muster the willpower to completely change your life. This is a difficult task. However, if you take the milestones step by step and the overall change is gradual, you can trick your mind into letting go of the status quo bias.
This is why many experts say you should leave some room for spending in your budget . Or, if you’re going to ruin your lifestyle, cut one area at a time: restaurants one month, gadgets the next, and so on. It can also be helpful to include a “ personal finance day ” in your schedule. This is a fairly straightforward first step, and you devote time to other small steps, such as lowering your cell phone bill or buying a new bank account.
Prejudice is not always a bad thing. Suppose you have a reliable set-and-forget investment portfolio and a crazy investor comes along and wants you to drop everything and invest in his new fund instead. A status quo bias, or even a choice bias, can save you from making impulsive and costly changes at this point. However, it is probably best to listen to the investor and then reject the idea based on your own in-depth knowledge and research. Typically, biases are blind spots, and while blind spots can sometimes work in your favor, they usually do more harm than good.