How Your Brain is Costing You Money: Cognitive Biases and What to do About Them
We’ve all heard of the sports fan who won’t wash their lucky shirt because they’re convinced it will cause their favorite team to lose. Or the gambler who just knows their luck is coming in the next round. But what drives this belief? Possibly some of the same thinking that costs us when we make poor money decisions: cognitive biases.
What are cognitive biases?
Cognitive biases are automatic thought patterns that are inaccurate and can lead to poor decision-making. This comes into play in all areas of your life, but can also impact your financial decisions and cost you money. Understanding these thinking patterns can help us make better decisions with our money.
But why would our brains play us like this? Our brains like to take shortcuts in order to make quick decisions and use less mental effort. The problem is these shortcuts leave room for errors and cognitive biases which lead us to illogical decisions.
Here are 9 common cognitive biases that could be costing you money:
1. The Sunk Cost Fallacy
Have you ever spent 30 minutes in a movie theater and realized you hated it? If you suffered and sat through the movie because you paid for the popcorn and the tickets, sunk cost fallacy is at work.
What is the cognitive bias of sunk cost fallacy?
When you’ve already invested a significant amount of effort and money into something, you’re more likely to be reluctant to abandon the strategy. The problem is, the sunk cost cognitive bias will lead you to continue investing, even if it’s no longer rational to do so. This can impact many financial decisions: from investing in stocks to continuing to pursue a degree you don’t plan on using.
Investopedia provides an example of how the sunk cost fallacy can impact our investing decisions.
“Jennifer buys $1,000 worth of Company X’s stock in January. In December, its value has dropped to $100 even though the overall market and similar stocks have risen in value over the year. Instead of selling the stock and putting that $100 into a different stock that is likely to rise in value, she holds on to Company X’s stock, which in the coming months becomes worthless.”
How to overcome sunk cost fallacy
If you think you may be falling prey to the sunk cost fallacy, ask yourself if the benefits truly outweigh the costs. Tracking the performance of your investments can help you see the big picture, rather than holding on to personal attachments.
2. Confirmation Bias
Confirmation bias leads us to seek out information supporting our existing beliefs. We then ignore evidence contradicting them.
How the cognitive bias of confirmation bias costs us money
This can lead to risky investment decisions, as you’ll ignore unfavorable news and opinions.
What to do about confirmation bias
To avoid the effects of confirmation bias, put your decision-making into perspective. Shift your focus to long-term goals instead of short-term ones. Additionally, seek out information that might disprove your beliefs so you aren’t listening to an echo chamber.
3. Gambler’s Fallacy
Gambler’s fallacy is one of the most well-known cognitive biases. It’s a thinking trap that leads to the false belief that if something happened frequently in the past, it is less likely to happen in the future (or vice versa). This can lead gamblers to believe they have a win coming after several rounds of bad luck, even if the odds are statistically the same.
How gambler’s fallacy costs us money
The gambler’s fallacy can lead investors to anticipate the opposite trend after the stock market follows a particular trend for some time. For example, if a particular stock has been consistently going down, this fallacy will lead you to believe it will begin going up again, tempting you to buy quickly.
How to overcome the money gambler’s fallacy
Avoid being tricked by this thinking by keeping up with market conditions and researching what is most likely, rather than relying on this mental shortcut.
4. The Law of Small Numbers
Quick (and hopefully painless) stats lesson: The Law of Large Numbers tells us that the larger a sample size grows, the closer its average gets to that of the whole population. This is statistically true.
On the other hand, the Law of Small Numbers is flawed thinking that leads us to believe that what is true for a small group is also true of the broader population.
How to overcome the law of small numbers
Remind yourself of this cognitive bias when making decisions based on a small set of data. Trust the statistics over your instincts that may be falling prey to gambler’s fallacy or other cognitive biases.
5. The Halo Effect
This cognitive bias leads us to fixate on one positive or negative characteristic when judging something while ignoring other important information. The halo effect plays a significant role in brand loyalty, which can have a high cost on your wallet.
How the cognitive bias of the halo effect costs us money
Brand loyalty ended up costing Kaitlyn $35 more over the course of a year when her family purchased Kerrygold butter, rather than the store brand. The worst part: they couldn’t even taste the difference between the butter. And that’s just on butter, think of all the other grocery name brands you could swap out. Or worse – the thousands of dollars you could save if you were just a little more open-minded about a different brand of a car.
How to overcome the halo effect
To avoid the cost of the halo effect, it’s first important to acknowledge your bias towards a certain brand. From there, being open to change and researching competitor brands can save you money.
Anchoring leads us to place too much importance on the initial piece of information received (AKA the “anchor”) and then make decisions based on that, instead of rationally considering all the options. Stores take advantage of this cognitive bias by placing cheaper items near the entrance. Seeing a low price (the anchor) makes all of the other prices seem more reasonable, even if they’re expensive.
How to overcome the costs of cognitive bias in anchoring
Steer clear of this consumer trap by making a list of the items you are looking for and the specific qualities you like in those items. Then evaluate items based on these criteria before making a purchase.
Anchoring can have much more consequential impacts when it comes to salary negotiations. When the HR person first gives an underwhelming offer, you’re more likely to feel better about the second offer, even if it’s still lower than you wanted. Luckily, you can use anchoring to your advantage by first asking for a salary higher than you are hoping for, making the salary you want seem more reasonable in comparison.
7. The Availability Heuristic
Things that are easier to recall happening seem more likely to us because of the availability heuristic. This can have a serious impact on your relationship with money. For example, we’re more likely to remember negative and stressful decision-making events, such as credit card debt or going over budget, rather than the times we’ve saved money. This can lead to the belief that you’re bad with money simply because the bad experiences are easier to recall.
How to overcome the cognitive bias of the availability heuristic
The illusion of control leads us to believe that we have more control over the outcome of a situation than we actually do. This may lead investors to feel they have control over the outcome of investments.
How to overcome the illusion of control that could be costing you
Getting a second opinion can help you gain a more accurate perspective of the situation at hand. This can mean looking at data, trustworthy articles on the subject, or discussing it with a friend. Additionally, taking the time to consider all of the outcomes, not just the one that is ideal for you, can help you make a more informed decision.
Similarly to the illusion of control, overconfidence can lead you to overestimate your own abilities and knowledge, ultimately leading to poor decision-making. This can lead you to believe you are a better-than-average investor, trusting your gut over the opinions and research of others.
One study found that 74% of fund managers believed themselves to be better than average investors, while the remaining 26% believed themselves to be average. This is a clear demonstration of overconfidence at play as it is not statistically possible for every fund manager to have better than average or average abilities.
Reviewing your past performance can provide you with a reality check, helping you avoid risky decisions driven by overconfidence.