Money

Cognitive biases and how they affect our financial decisions

Published on October 14, 2019 1:19 am, by

What are Cognitive Biases?

A Cognitive Bias is a mental model that we use, subconsciously, to make decisions. We have lots of these mental models and they generally make life easier by simplifying decision making.

But they can also cause problems when they lead us astray and we make incorrect decisions. Worse still, it’s possible that our decision making can be manipulated by marketers who anticipate the way we will use them.

In this article, we outline some of the main cognitive biases that affect our financial decision making and how you might be able to mitigate them. But remember, it takes practice. Many of these biases are etched deep in our minds and have developed over many years.

Present Bias
This bias relates to the way that we place greater importance on things in the short term than the long term and it has a massive effect on how most people manage their money. In simple terms, you could think of it as impatience or a preference for immediate gratification. The effect it has is that we tend to overvalue things in the short term and/or undervalue things in the long term.

A simple example of Present Bias in action would be offering a friend $10n today or $15 tomorrow and they decide they prefer $10 today.

In terms of our money, it makes it harder to save a deposit for a home for example, because the sacrifices we have to make it the short term seem bigger than the benefit we imagine in the long term. Similarly, it makes it harder to pay off debt because we have to avoid spending money in the short term (which seems more difficult) for a benefit that seems a long way off. It also makes it more difficult to save for retirement because putting away money that we could spend now seems to hurt more than the benefit we imagine from having more superannuation in twenty, thirty or maybe forty years.

Loss Aversion
Loss Aversion explains why people often experience more disappointment from losing something than the pleasure they get from acquiring the same thing.  In fact, it is generally thought that the pain of losing is psychologically about twice as powerful as the pleasure of gaining. It makes people more willing to take risks to avoid a loss than to make a gain.

You can see countless examples of Loss Aversion in action with products and services that offer free trials. Of course, many free trials are genuinely about giving you the opportunity to experience the product or service. But marketers also know that once you have experienced something it will be harder for you to give it up.

In terms of our money, Loss Aversion causes us to spend more than we need to. For example, we spend money on subscription services that we value more only because we already have them. We would value them less if we didn’t have them. We might not even use them, but we are worried about not having them and what we might miss out on.

We can mitigate Loss Aversion by considering things like subscription renewals as separate purchase decisions. Each time a subscription renews we should try to consider if we were starting from scratch would we make that decision. It might also help to use a “trial separation” to prove to yourself whether you really need a product or service. If you can prove to yourself that you don’t suffer by not watching a streaming service for a week that might be enough to overcome the irrational Loss Aversion.

Default Bias
Default Bias refers to the tendency people have to find whatever the default option is for a decision more appealing than they should. You can almost think of it as the “do nothing” option because the option has already been selected. In fact, it is also related to the Loss Aversion bias that we described above. The perceived loss from changing from the default option is often greater than the perceived value from changing – so people just accept the default option.

You can see simple examples of Default Bias in action every time you fill in a form. Often the form has default options. These default options will have a significant effect on the options selected when people fill in the form. If you were designing the form and you wanted people to choose a specific option you would make that option the default. Default Bias would almost certainly result in more people selecting that option.

In terms of our money be wary about completing application forms or signing contracts with default options. You need to take the time to properly consider each option and make a rational decision about the option you select. It might just be that the default option is the best option for the product or service provider and the most expensive one for you!

Status Quo Bias
The Status Quo Bias explains why we are often reluctant to switch from arrangements we already have in place. It is related to the Loss Aversion bias (described above) and other concepts like Sunk Cost thinking and Regret Avoidance. Whilst, in theory, it seems irrational that people don’t switch from one arrangement to a better arrangement it is much simpler to stick with an option that we know has worked in the past. Similar to Loss Aversion there is also some evidence that people have greater regret for bad outcomes from a change than the bad consequences of inaction!

You can see examples of Status Quo Bias every day when we fail to switch to things like cheaper energy plans and health insurance plans or to better products and services because we are familiar with the ones we already use.

In terms of our money, you really need to challenge the Status Quo. The Status Quo costs consumers thousands of dollars a year because people won’t swap banks, insurers, superannuation funds, and grocery brands. Take the time to build a list of advantages and disadvantages for a particular product or service that is renewing and approach each decision as starting from scratch.

Denomination Effect
The Denomination Effect refers to our willingness to spend money on lots of smaller amounts rather than the same total value in one large transaction.

You can see examples of the Denomination Effect in our day to day spending. For example, would you be more comfortable spending $28 on coffee in a week in 7 transactions of $4 each, or paying for $28 in one transaction (for the same amount of coffee over the same number of days)? Whilst there are all kinds of factors that might sway your decision, most of us would think more about the larger transaction, despite the fact it’s the same amount of money.

In terms of our money, this is an important issue. We can use the Denomination Effect to re-frame how we spend our money. Instead of thinking only about each individual, small value transaction for say a subscription service, think about the total cost of the subscription service over say a year, or over your lifetime. The larger the value you think about the more thought you will put into the spending decision. This might help you re-evaluate some of your spending and allow you to use some of the savings to pay down debt.

Anchoring Bias
Anchoring Bias refers to our over-reliance on an initial piece of information we have about something (the “anchor”)  in making subsequent decisions. You could think about it as setting a baseline or a starting point, which might be helpful but also can incorrectly set an expectation that influences our decisions.

A simple example might be if I asked you whether Ayres Rock was higher or lower than 1500 metres and how high do you think it is? Anchoring Bias suggests you are more likely to give an answer closer to 1500 metres than if I simply asked you how high Ayres Rock is. This is because the information in the first question, the 1500 metres, is used as an anchor.

In terms of our money, Anchoring Bias affects us all the time.   Almost everyone that tries to sell you something will use Anchoring Bias. They’ll show you an expensive version of the product first and from that point on everything else will seem cheap. Anchoring Bias is also used by sellers when they promote discounts.  They’ll make sure you can still see the original price and of course, the discounted price seems like an absolute bargain – partly because you’ve been anchored to the original price.

You can counteract the effect of Anchoring Bias by resetting the anchor. Instead of working your way down from the highest-priced version to the lowest, work your way up from the cheapest to the most expensive, pausing to justify the extra expense. When you are looking at a discounted product put the original price out of your mind and consider only the discounted price, or do some research and make sure the “original price” is actually the real market price. Often the real market price will be less than the quoted original price and having a smaller anchor in mind will make the discount seem like less of a bargain.

Bandwagon Effect
The Bandwagon Effect explains our tendency to make decisions to fit in with the crowd or the “norm”. We all do it, and to some extent, it makes a lot of sense. But sometimes we make decisions or choices that we don’t really need to because we overestimate the importance of going along with the crowd.

A simple example would be rushing to upgrade our phone because a new model has been released and everyone else seems to be upgrading. Rather than considering whether the upgraded phone actually provides any real tangible value we might overestimate the benefit of jumping on the bandwagon. So we spend more money than we need to on things that we don’t really need.

You can counteract the Bandwagon Effect by slowing down financial decisions and considering them more rationally. Slowing down the decision might help you properly appreciate whether there really is any benefit from following the crowd. Perhaps make a list of the advantages and disadvantages of a decision and evaluate them rationally.

Choice Supportive Bias
After we’ve made a decision most of us want to feel good about it so we tend to retrospectively convince ourselves the decision we’ve made was the right decision even if it wasn’t. We might do it by overestimating the value of the decision we made or by devaluing the options we didn’t select.  In fact, what we tend to do is remember the positive aspects of the option we selected and the negative aspects of the choices we rejected.

A simple example of Choice Supportive Bias might be purchasing a particular make and model of a car. After making the purchase decision you are more likely to focus on all the good things about the make and model you purchased and the negative things about the ones you didn’t. If there are faults or recalls about the options you rejected you will identify those and remember those.

In terms of our money, the problem with Choice Supportive Bias is that it can result in bad repeat decisions or purchases. If we overvalue a particular decision we’ve made we are more likely to make the same decision again. We might also influence friends and family to make the same decision.

We can counteract Choice Supportive Bias in a number of ways. First, try to be honest about the decisions you’ve made. There are good and bad things about most decisions. Try to consider each purchase decision as a brand new decision – you don’t have to make the same decision again. Try instead to reflect on what you learned the last time you made that decision. Also, keep in mind that sometimes you can reverse a decision. You might be able to return something you’ve bought. There might be a “cooling off period” that allows you to change your mind.

More information on financial decision making and cognitive biases
There is plenty of information available on the internet about financial decision making and cognitive biases. Just use your favourite search engine to search for “cognitive bias” or “behavioural economics”. This Ted Talk by Dan Ariely is also an amusing introduction to the topic.

 

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Peter is the CEO of MoneyBrilliant. He has over 20 years experience in banking, insurance and accounting. Peter has three sons, ranging in age from 16 to 3, is a sport and fitness fanatic and a volunteer firefighter. He is passionate about improving people's lives through making financial services more accessible.

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