This post is by our regular contributor, Erin.
I love psychology, and I love personal finance. It’s fascinating to analyze why people make certain decisions when it comes to their money.
I’m willing to bet there have been a few times you’ve questioned your own decisions after the fact. Like, Why didn’t I say no to that sale? or Why didn’t I negotiate a lower price on my car? or What made me so confident about that particular stock?
If this has ever happened to you, or you’re trying to get to the root of a money problem you have, it can actually pay to be aware of the various subconscious and sometimes dangerous cognitive biases you have toward your money.
Read on to find out what 5 common cognitive biases can negatively impact your finances, and how you can avoid the trap.
What the Heck is a Cognitive Bias?
Let’s start with the definition of what a cognitive bias is so you can understand why we’re talking about it. From good old Wikipedia:
Cognitive biases are tendencies to think in certain ways that can lead to systematic deviations from a standard of rationality or good judgment, and are often studied in psychology and behavioral economics.
Basically, our brains are wired to act in a certain way that doesn’t always benefit us, unbeknownst to us. This can obviously have an impact on the financial decisions we make, just look at the examples below!
1) Social Desirability Bias
This is exactly what it sounds like – the tendency to over-report things about us that we think are socially acceptable, and to under-report things that might make us look like the odd ones out.
Does this remind you of anything? It’s pretty darn similar to keeping up with the Joneses. You want to appear like you fit in with the crowd; not like you’re going against it.
Unfortunately, that’s probably going to lead to debt or to unhappiness as you’re forcing yourself to conform to the norm. Don’t be afraid to go against the majority and embrace improving your financial situation!
Most of the time, people are too concerned with what’s going on in their own lives to care about what’s happening in yours. That’s a good thing! You need to focus on yourself because no one else is going to care about your money as much as you do.
Plus, by being true to yourself, you’ll likely attract other individuals with the same values, lessening the need to “fit in.”
2) Sunk Cost Fallacy
This is one I am completely guilty of, and I bet you are, too. At some point in most of our lives, we’re going to spend money on something that we don’t use for one reason or another. Tickets to an event, food, a plane or train ticket, makeup we end up disliking, etc.
Sometimes we can’t help it. But we still feel like crap about spending money for what ends up being no reason. So we’re tempted to go ahead with the original plan anyway, even if we don’t want to. This is known as the sunk cost fallacy.
You’ve already spent the money. It’s gone, regardless of what you choose to do. However, because you committed the funds, you feel compelled to follow through.
I have a hard enough time spending money that when something happens (say a health issue), I feel like I need to get my money’s worth, even if I won’t enjoy it.
That doesn’t make logical sense, does it? Well, that’s kind of the premise of cognitive biases. The best way to deal with a sunk cost is to accept it and move on. Going through with something just because you spent money on it isn’t going to make you feel better, trust me!
3) Denomination Effect
This is almost a professional, fancy name for the latte factor. It states that individuals are likely to spend more money when they have $1, $5, and $10 bills, versus $50 bills or benjamins.
I don’t know about you, but having a $100 bill in my possession makes me think twice about spending as opposed to having a $1 bill. It’s just so beautiful, you don’t want to spend it. $1 bills? Eh, who cares, make it rain!
Clearly, the solution is to carry around more $100 bills. (I’m kidding, don’t do that!) I’d suggest trying the envelop budgeting method, not using cash (if it slips through your fingers easily and you have a better time using credit), and tracking your spending.
Also, show some compassion to the dollar bills out there. They need love, too.
4) Confirmation Bias
We all like to be right…right? It’s only natural we seek out opinions or facts to validate our beliefs. Unfortunately, that can be very dangerous to our finances, especially when it comes to investing.
Maybe a friend or coworker of yours recommends a certain investment in passing and urges you to look into it because they’ve had success with it.
You’ve already got it in your head that this could be a good thing, so you go online to do some research. When you see proof that goes against the recommendation, you might be quick to dismiss it because you don’t want it to be true.
You’re already biased in favor of this recommendation and your judgment is clouded. This is a classic example of a cognitive bias.
What can you do? Research thoroughly and with an open mind. Your friend/coworker likely isn’t an investment expert, and just because something is going well for them now doesn’t mean it will continue. Some people just get lucky; you don’t want to invest based off of luck.
5) Bandwagon Effect / Herd Mentality
This can be best summed up as your parents asking you the age old question, “If so and so jumped off a bridge, would you follow them?”
This also goes along with the social desirability bias. Having a dissenting opinion can make for a lonely existence. Having different values and opinions makes you a target, and no one wants that.
Let’s look at an example. Whenever a new Apple product comes out, it’s like a wave sweeps the nation. It seems like everyone needs the latest model (unless you’re staunchly a supporter of Android).
It’s like a bunch of people get infected with “Apple fever” – people who don’t even know what the Apple watch is capable of are buying it because why not? Everyone else is! There’s no thought that goes into it; they’re blindly following the herd. Not having an Apple watch might make you feel left out.
What’s the solution? Define your values and stick to them, whether they make you stand out or not. It’s perfectly okay to be using a 2 or 3 year old phone, or even flip phone, if that’s what provides value to you. Don’t let others influence your thinking to the point where you no longer think for yourself.
________________
There are many other biases that can affect how we manage our money, and I encourage you to look into them. Anchoring is a popular one, and I’d argue that believing you’re “saving” money by buying something on sale is another. Spending $0 is truly saving money.
Hopefully by being aware of these biases, you can avoid falling into a trap in the future!
Have you ever mismanaged your money because of one of these cognitive biases? Which do you think are the most common? Which ones are the most dangerous?
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I have definitely experienced each of these at one point or another. It’s difficult to avoid all of them all of the time. However, knowing that they exist is certainly a big part of developing a concrete plan and becoming a better saver/investor.
RetirementSavvy Being self-aware is huge. You can’t avoid these cognitive biases if you aren’t aware of them and how they impact you.
I’m probably most guilty of #2. I can justify almost anything if I really put my mind to it…actually I don’t even really need to do that. :)
Beachbudget Same here! It kills me so much to think of “wasted money” but logically, if I go and don’t enjoy it, it’s still a waste. Better to do something else I’d be happier with. (Hard to believe that in the moment, though.)
DC @ Young Adult Money RetirementSavvy Exactly! It’s much easier to pay attention to how you’re reacting when you know you can be susceptible to these biases.
I definitely have problems with sunk-cost. When I was taking accounting classes, there was an emphasis on not taking that into account when making a decision. Because you bought a car you can’t afford, you might be tempted to make it worthwhile by driving it more. But if the bus is cheaper…
AbigailP Ah, true! That’s a great angle to view it from. Thanks for sharing that!
Totally guilty of sunk-cost but recently went on a massive minimalism purge and let it all go! Feels so good!
HeatherShue I did that a few months ago! It’s worth getting over sunk costs. I got addicted to getting rid of stuff. =)
The denomination bias is really a funny one, and one that I can totally relate to. When I was in high school/college one of my main jobs was waiting tables. At the end of the night, the manager usually cashed out our tips in higher denominations (like $20s), but I would often have a small stack of $1s and coins that people left on the table. I would always spend those within a day or two- I hate to admit how much money I went through in small denominations.
One time, I paid for a pizza order (like $30 plus a tip) in singles. WTF-deposit your money kids.
Hannah UnplannedFinance Ha, oh man! I definitely liked “collecting” smaller bills when I was younger. My mom would always trade me and give me like, two 5s and ten 1s for a $20 bill. It’s silly what we’ll do with money sometimes!
I haven’t thought about cognitive psychology since college! Great post!
Denomination effect is the real deal and credit cards only make it worse! I remember getting a $50 bill growing up for Christmas and not wanting to spend it on anything :)
Millennial Boss Thanks, it was one of my favorite courses. =) That’s a perfect example! I had the same thought process when I was a kid. The larger bills seem more important/special and you want to hold onto them.