Everyone hates to lose money, but ever stop to realize that for most of us the pain of losing money hurts more than the joy of finding money? It’s called “loss aversion,” and it is one example of what behavioral psychologists call a cognitive bias. Cognitive biases are generally thought of as statistical errors in our brains when considering probability—or stupid decisions we make while operating on autopilot. Bandwagon, groupthink, and herd behavior are good examples of cognitive biases, and if you’re human, there’s really no way to escape them. They affect almost every decision we make—including financial, and it can cost you money if you’re not paying attention.
We’re not victims or helpless to cognitive biases, just likely to follow them by reflex. Several biases that can empty your pockets are:
- • Time discounting: Our tendency for immediate gratification. (“I’ll buy this $30 book and take it home now rather than paying $19.99 online.”)
- • Denomination effect: We are less likely to spend bigger bills. (“I just broke this $20, so ‘whoosh’ watch that disappear.”)
- • Overconfidence: We base financial decisions on expertise we don’t actually have or from unreliable sources. (“I’ve watched the market for 20 years; I know what I’m doing.”)
- • Post-purchase rationalization: We usually convince ourselves that we are thrilled with a purchase rather than accept that we wasted the money. (“I needed a new purse anyway and this was only a couple hundred dollars.”)
- • Statas quo bias: We tend to stick with what we know even whether or not it’s in our best interest. (“I’ve always invested with a 401(k), so I’ll just keep doing that to save for retirement.”)
These are just some of the cognitive biases that influence us to spend more, save less, and feel more confident in our decisions than perhaps we should (Business Insider). Even though we can’t delete cognitive biases from our brains, if we’re aware of them we are more likely to make deliberate good decisions.
What you can do
If consistently making knee-jerk, reactive decisions about your finances is dangerous and expensive, what’s our alternative? Regardless of whether you’re buying new golf clubs or adding to your retirement savings, you can take advantage of the space between stimulus and response to make smart financial decisions. Here are a few approaches:
- • Don’t make important financial decisions when you’re stressed, tired, or multi-tasking.
- • Reflect on past experiences with similar types of purchases. If you know you’re vulnerable when you go to a car dealer, take a backup person to help you reason.
- • Use scarcity mentality to your advantage. Knowing your current funds are limited forces you to be more productive about how to use them.
- • Gather information and consider all of your options.
- • Consider what you will be missing if you just walk away.
- • Come up with a “time out” method to redirect yourself to a more logical path.
When you are sensitive to time pressures, negative emotions, and other stressors, using these techniques can help you outsmart your own financial biases. If you’re interested in researching more about why humans do what we do and how it affects economics, read Freakonomics and explore other media from Steven D. Levitt and Stephen J. Dubner.
A better way
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