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How cognitive biases influence our financial decisions

Posted 07.09.2020
How cognitive biases influence our financial decisions

When it comes to money, you can’t always trust how your brain works. There are times when you might believe you’re spending money reasonably and wisely. But the truth is, your brain can influence you to make bad money decisions without you even realising it. This is what we call cognitive bias, and in this article, we look at the most common cognitive biases, how they influence your spending habits, and how to overcome them.

Bias #1: Sunk Cost Fallacy

Bestselling author Rolf Dobelli once said, “The sunk cost fallacy is most dangerous when we have invested a lot of time, money, energy, or love in something. This investment becomes a reason to carry on, even if we are dealing with a lost cause.”

A good example of sunk cost fallacy

Let’s say you buy a car that is in bad condition. You try and fix everything wrong with it, including the tires, brakes, and radiator. After spending about R7000, the mechanic tells you the engine needs to be repaired. At this point, you’re starting to make a loss, but you tell yourself, “let me just pay for the engine; otherwise all the money I have already paid will go to waste.”

What’s the solution?

Don’t throw good money after bad money as this will only result in greater loss. Accept that you can’t recover any sunk costs and try to save your money by making better decisions in the future.

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Bias #2: Group Thinking

The famous novelist Mark Twain said, “When you find yourself on the side of the majority, you should pause and think.” This is because you can be influenced to spend money so you can fit in with the people in your group.

A good example of group thinking

If your co-workers always buy lunch, you will spend more money taking part in this habit. Even when you could save money by bringing a lunch box, you’re more inclined to copy what your peers are doing.

What’s the solution?

Understand that your situation and budget might be different from what other people are experiencing. Sometimes peer-pressure forces you to go out of budget, but when you have money troubles, you might have to face them on your own. Therefore, it’s better to buy something because you can afford it, not because you want to fit in.

Bias #3: Framing Effect

It’s not what you say; it’s how you say it. This is a motto most companies use to market their products. They use the right combination of words to influence you to ignore facts and buy their stuff.

A good example of the framing effect

You walk into your favourite shop and see an item going for R200. You’re more likely to buy it if it says 50% off because you automatically think you’re lucky for buying it at such a low price. In reality, you’re still spending money, and the framing effect might trick you into buying unnecessary things. 

What’s the solution?

Every time you shop, try and remember that most companies will present their information in an attractive way. If they offer you a buy 1, get 1 free deal, think about the real facts. Is it really cheap and do you really need it?

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Bias #4: The Anchoring Effect

This is when you use information that you already know or, the first piece of information you hear to decide if buying something is a good idea.

A good example of the anchoring effect

You walk into a shop and find that the phone you want to buy costs R3000. In the next shop, you see it going for R2400. This may still be more than you had budgeted for, but because you’re using R3000 as your anchor, the second phone seems much cheaper, so you’re more willing to buy it.

What’s the solution?

Realise that you’re biased because of the anchor you’re using. In the example above, it is better to delay buying the phone until you find more information that confirms whether buying the second phone is a good decision.

Bias #5: The Ostrich Effect

Life coach Archibald Marwizi has been quoted saying, “The ostrich approach, which consists in burying your head in the sand when confronting your areas of weakness, becomes a self-set trigger for failure.” Humans sometimes behave like ostriches in order to avoid bad financial news.

A good example of the ostrich effect

You go on a shopping trip to your local mall, and you keep buying things without checking your bank balance. Deep down, you’re afraid that you have spent too much money, so you avoid looking at the numbers. That means you’re spending money blindly without a budget.

What’s the solution?

In order to make better decisions with your money, you have to face the truth head-on. If you have overspent, quickly looking at the total cost will help you avoid more unnecessary spending.

Here are more cognitive biases to look out for when spending money

So far, we’ve looked at some common examples of cognitive biases that influence your financial decisions. However, there’s more. The following cognitive biases and their examples are also worth knowing:

  • The spotlight effect – This is when you think other people notice you and pay a lot of attention to what you do. For example, you might buy an expensive outfit to impress your co-workers, but in reality, they hardly notice what you wear.
  • Confirmation bias – If you want to buy an iPhone, you will only look for and listen to information that supports your decision. You’re likely to ignore any negative information about iPhones.
  • The denomination effect – It’s easy to spend more money when your wallet is full of R10 notes. However, if you have just one R200 note, you’re less willing to break it down.
  • Time discounting – You’re more likely to spend money on a holiday trip that is 2 weeks away than save for a retirement which is 10 years away.
  • Status quo bias – Because of emotional attachment to specific products, you might resist changing things and finding better options even if the product becomes too expensive.
  • Blind-spot bias – This is a big one. When you spend money, but you try to convince yourself that you’re not biased, you might be suffering from blind-spot bias. In fact, blind-spot bias can keep you from recognising the cognitive biases mentioned in this article. A bit like an inception bias.

Some final words on cognitive biases

As you can see from what we’ve outlined, cognitive biases are numerous and happen more often than we think. With the help of this article, you will train your brain to recognise these sneaky influences. When you beat these mind tricks, you’ll make better financial decisions that will help you better manage your finances.

Photo by Diego PH on Unsplash