Many people believe that being good with money is just about dollars and cents and following the rules. And that’s a lot of it, but not all of it. While it’s easy in theory to stick to the plan, your brain has a lot to do with why you can’t always follow through. Math is math and numbers are numbers: There’s no wiggle room in 2+2. But our brains don’t work that way all the time. The psychology behind spending is complicated and deceiving, thanks to something called cognitive bias.
What is cognitive bias?
Anytime you do a little “magical thinking” to undermine the rules, you’re falling victim to cognitive bias. Have you purchased a product that wasn’t your first choice because you “came all this way and you’re not leaving empty handed!”? That’s the sunk-cost bias in full effect.
Here are the top 5 ways your brain is playing tricks on you and what you can do about it.
Status quo bias
The status quo bias is evident when people “prefer things to stay the same by doing nothing or by sticking with a decision made previously.” Say you don’t particularly like a certain bakery, but it’s the one your family has always used birthday cakes. It’s easy, they know you, and it’s what you’re used to. Why change? What if you try a new bakery and no one likes it? When you consider your current state of affairs as the best and only option, any change will be seen as a loss.
Regarding investing, the status quo bias is especially prevalent with banking. If you’ve been with the same fund for years despite their high fees and low returns – get out! Take a few hours to research your options and find a better investment platform.
The bandwagon effect, also called the herd effect, is observed when people “go along with what others do or think without considering their actions.” This phenomenon is named for the political term “jumping on the bandwagon,” which refers to the tendency of voters to align themselves with the largest and most successful campaign. It refers to an actual wagon that a politician used in the 1800’s while campaigning.
When a product becomes super popular and everyone you know has one because they "heard good things about it" or "think it's a neat company" – that’s the bandwagon effect.
A lot of times the people are right, and it is an excellent product. A lot of times they are wrong. Right or wrong, they’re buying the product, driving up the demand, and making the company tons of money. Only you can tell if a product is good for you. Always do your research. Remember the Pet Rock? Everyone loved that!
Sunk cost fallacy
Also known as throwing good money after bad, this is seen when a person makes a decision about the future based on irreversible choices from the past. The classic example goes something like this: You have purchased a non-refundable (and non-transferable) movie ticket in advance. When the time comes, you don't feel like going out. Since you would actually enjoy yourself more at home, do you go to the movie or not?
Going to a movie you don’t want to see just because you’ve already spent the money is the sunk cost fallacy at work.
It presents itself all the time in finance and investing, but often more so for entrepreneurs. Your big idea is your baby, but not all ideas work out. After you’ve spent so much time and money on an effort it can be hard to let it go. Using objective and rational thinking is your best friend. Be honest and don’t feel obligated to see a failure through just because it’s your failure.
Choice-supportive bias is when you only remember the positive attributes of a choice you made in the past. It's part of the explanation behind brand loyalty, and whether you realize it or not, it colors every future decision you make in a bad way.
No one likes to be accused of poor judgment and we defend our past choices to the end. Take buyer’s remorse for example: When you’ve been taken by a salesman or bought something that you regret purchasing for any reason, you’ll feel bad about it. But when you defend your original choice, even though you know it was wrong, that is the choice-supportive bias at play.
How can you avoid it? Make decisions about future purchases based on the current facts at hand, not the way you remember them. And if you make a bad choice, don’t defend it. Own it and move on.
The anchoring effect
With the anchoring effect, the first version of a thing you see becomes the ‘anchor’ for all future versions. This effect is heavily in play when you go shopping and it’s what sales are all about. Say you walk into a store and see a gorgeous bag that you just have to have. Great! You look at the price: $1,000. Not great! But just a little farther back they’ve got a similar look in a bag that costs just $300. Your brain is tricking you into thinking that you’ve saved $700 by buying the second bag.
Another real life, non-financial example of this is housework. If a husband is doing cleaning than his dad ever did, he may feel really good about his contribution. Imagine his surprise then, when his wife complains about him for not doing his fair share. His anchor is what his dad used to do. Her anchor is the amount of housework she does.
To beat this anchoring effect, you really need to train your brain. You need to consider all of the available information, not just the most convenient to you.