Biases That Can Lead to Financial Mistakes
A bias is an illogical preference or prejudice and it is a uniquely human trait. We all have biases. In our personal lives and in our professional lives, biases can have a great impact. Sometimes our inherent biases are good, but other times they can hurt us and our progress. Psychologists have identified dozens of different kinds of biases, and any or all of them can cloud our judgment and affect our money management skills. In finances, cognitive biases can cause us to make decisions that are detrimental to our financial wellness, such as saving less, spending more, and making overconfident or rash decisions when we aren’t fully informed. Making decisions is hard — especially ones that majorly impact our wallets.
Once you start recognizing your own cognitive biases as they appear in real time, some simple tweaks in your thinking will put you back on the path to financial prosperity. So I’ve put together a guide of the most common cognitive biases that impact our finances so that we may avoid them. I will cover biases that impact spending, saving, investing, and credit.
Biases That Impact Spending:
The Bandwagon Effect:
One of the cognitive biases that impacts spending the most is the bandwagon effect. The bandwagon effect is also known as “Groupthink”. This is the phenomenon where people tend to align their beliefs and ideas with respect to the proportion of others who have already done so. So basically, this means “monkey see, monkey do”. How this translates financially, is that if you see your peers spending their funds frivolously, you may begin to do so as well or if you don’t see your peers saving or investing you may not as well. It sounds stupid, like “Oh, I don’t follow the crowd. I am my own person”. However, this bias can be sneaky. Have you ever gone to a dinner or to grab drinks when you couldn’t afford it because your friends invited you and you felt obligated? Or have you ever gone on a trip you couldn’t afford because you were invited? Or have you ever bought christmas presents you couldn't afford because it's christmas and everyone else is doing it, so you feel obligated? Those subtle things are all the result of bandwagoning!
The way to conquer this bias is to ask yourself when you are making money moves, or lacking money moves, why are you making the decisions you are making? Have you come to the choices you’ve come to because others are doing them, or because they are what is truly best for you and your financial future? Always just take a step back before making financial decisions and examine your motives. It could save you time, energy, and money.
Post Purchase Rationalization:
The next cognitive bias that affects spending is post purchase rationalization. This bias is justifying spending to comfort your buyers remorse. For example, you may buy an expensive purse and tell yourself “ Oh, I actually really needed that purse”, knowing that you could have lived without it or with something not as expensive. Whenever you find yourself doing this, always remember that if you regret it and feel the need to rationalize the purchase, you may want to return it.
Denomination Effect:
Another cognitive bias that affects spending is the denomination effect: The tendency to easily spend smaller bills than larger bills. You may hold off on buying that brand new $1000 TV, but if you buy a whole bunch of $20 items on Amazon it can still really add up. Small bills add up. A good way to adjust your mindset when you encounter yourself exhibiting this bias is to create a monthly budget, stick to it, and then analyze your spending at month's end. It is easy to create a budget, but it can be hard to stick to it. The only way to really hold yourself accountable is to analyze what you actually spent your hard earned money on at the end of the month. If you notice a whole bunch of small unnecessary charges you can adjust your spending next month.
Biases That Impact Saving:
Time Discounting:
The first cognitive bias that impacts saving is time discounting, or the need for immediate gratification. I like to call this one frivolous online shopping. Online shopping is so instantaneous and easy that we don’t give it a second thought. Plus, with all of these advanced algorithms showing us ads for things we are more inclined to like it is harder than ever to resist and save that money instead. A good way to overcome this is to wait 24 hour before your purchase. If you still want to buy the item and you feel like its a good buy, then you can purchase it the next day. No biggie.
Status Quo Bias:
The feeling of complacency stops a lot of people from changing their spending habits to create savings. A lot of people keep the same phone carrier, internet provider, car insurance, car, job, partner, or even home at a financial detriment to themselves because it is what they know and are comfortable with. Analyze your daily decisions to see if it's really the best option for you, both financially and personally, and if you realize it might not be don’t let your fear of change hold you back from making the right decisions.
Restraint Bias:
The third cognitive bias that impacts saving is restraint bias; or the overestimation of your self control. Girl, you know you can’t control your spending in Sephora, so only go if you have budgeted money to spend there. Know your limits.
Biases That Impact Investing:
Loss Aversion:
This happens when the fear of losing is so great that you don’t even try to play the game. Loss aversion is the bias that occurs the most in investing, or the lack thereof. Many people do not invest because the pain of losing is psychologically twice as powerful as the pleasure of gaining. So many people do not even try to begin investing, even in low risk vehicles, because of loss aversion bias. When you see yourself encountering this just remind yourself that there are relatively safe investment vehicles out there, but the greater the risk the greater the reward. Scared money don’t make no money! (But please, always do your homework and invest wisely.)
Hindsight Bias:
Hindsight bias allows people to convince themselves after an event has occurred that they had accurately predicted it before it happened. This can lead people to conclude that they can accurately predict other events, like the movement of the stock market. Just because you guessed that something was going to happen or not going to happen and were right, does not mean that your guess will be correct next time. Humans cannot predict the future… yet, or that we know of, so please do not let hindsight bias affect your future investment choices. Always make investment choices rationally and only after doing your research.
Confirmation Bias:
This is the tendency to interpret new evidence as confirmation of one's existing beliefs or theories. Confirmation bias can make people less likely to believe information which challenges their views. Even when people do get exposed to challenging information, confirmation bias can cause them to reject it and, perversely, become even more certain that their own beliefs are correct. To avoid confirmation bias look for ways to challenge what you think you see. Seek out information from a range of sources, and try to consider situations from multiple perspectives. Alternatively, discuss your thoughts with others to seek outside opinions.
Cognitive Biases That Impact Credit:
Procrastination:
We all know how procrastination works, but how does it affect your credit? We often procrastinate on building our credit because we hold off on paying off our debts. You tell yourself that once you get that raise you will start tackling what you owe. Newsflash! If you hold off on paying your debts they will only get larger! Pay off your debts as soon as possible so that you can break the cycle. I know getting out of debt can be scary and even crippling for some, but the sooner you begin the sooner you will be debt free and the less you will have to pay in the long run.
Optimism Bias:
This is a cognitive bias that causes someone to believe that they themselves are less likely to experience a negative event. This leads some optimistic people to only focus on benefits, but at the same time ignore risks and costs. The only way to avoid this bias is to always do your research and consider all risks, costs, and rewards.
Cognitive biases are ‘hard wired’ and we are all liable to take shortcuts, oversimplify complex decisions, and be overconfident in our decision-making process. Understanding our cognitive biases can lead to better decision making, which is fundamental to lowering risk and improving our finances over time. So make sure you are aware of your own biases and try to correct them when you can. This will get you one step closer to financial freedom.