Cognitive biases are responsible for some of our worst financial decisions - yet many people aren't even aware they exist.
When we fail to make a good decision about how to save or spend money, we often cast it in moral terms. We fault ourselves for not sacrificing enough, or for not having the willpower to resist our financial temptations.
Yet there's much more going on beneath the surface. Good money management isn't simply about trying harder or overcoming our shortcomings. In fact, in many ways we're programmed to fail. Human beings are riddled with powerful cognitive biases that can easily undermine and thwart our best intentions. While we might be cognizant of the financial mistakes we're making, and feel determined to make changes, these biases are often so deeply ingrained that they prove extremely difficult to overcome.
Here's the truly troubling part - sometimes we aren't even aware our biases exist. This is one reason why so many people are confounded by the fact that they never seem to get anywhere, despite their best efforts to spend and save more efficiently.
With that in mind, let's review some of the most common cognitive biases that afflict us - and what we can do to mitigate their effects.
Anchoring Bias
Humans have a strong tendency to privilege the first bit of information they receive when making a decision. This effect, known as anchoring bias, can play a decisive role in negotiations, financial management, and day-to-day decision-making.
One of the problems with the anchoring effect is that if the first bit of information is faulty (as is often the case), then all subsequent decisions are suspect. One example: The initial price a salesperson asks for a car anchors the rest of the negotiation. Offers that are lower than this initial price seem like bargains - even if they are still higher than the car's actual value.
Falling victim to anchoring bias may result in spending more money than necessary, or accepting a suboptimal negotiated deal, such as the aforementioned car sale or a salary offer.
Endowment Effect
Sometimes also referred to as the "ownership effect," this bias is responsible for our privileged feelings toward objects we already own. Research studies have shown the effect of this bias in action, showing that people will pay more to keep items they already possess rather than pay for something of equal value they don't own.
Studies have also shown the mere act of touching an item can instill feelings of ownership. Combined with the endowment effect, that's a recipe for significant overpayment.
The Sunk Cost Fallacy
Nobody likes to take a loss. In fact, sometimes we're so desperate to avoid that scenario that we ultimately end up doing far greater damage than we would have by simply cutting our losses.
If you've ever heard the phrase "throwing good money after bad" then you're familiar with the negative effects of ignoring sunk costs.
Present Bias
Have you ever bought a bunch of bananas only to throw most of them out after they've turned brown? Or signed up for an expensive gym membership that you rarely use? Then you're familiar with the effects of present bias.
Humans tend to believe that our wants and desires remain largely static, yet that's not true. We also love to procrastinate. Unfortunately for us, the longer we wait, the more expensive things tend to be.
Planning Fallacy
Somewhat similar to procrastination, planning bias describes our tendency to underestimate grossly how long certain tasks will take, or how much effort will be required.
According to the Center for Retirement Research at Boston College, roughly half of Americans have no retirement savings - a problem that can be partially blamed on the powerful effects of the planning fallacy.
The Takeaway
Cognitive biases are responsible for some of our worst financial decisions - yet many people aren't even aware they exist. By being conscious of their power, you can mitigate their effects while minimizing irrational financial decision-making.