Ever wonder why you doubled down on a bad investment, even though you kind of knew it was a loser? Or impulse bought an expensive gadget, knowing full well you would barely use it in everyday life? Welcome to the wild world of cognitive biases in personal finance!
Biases are sneaky mental shortcuts that our brain takes when processing information and making decisions. And sadly, they usually work against us when evaluating choices involving money. š©
From the “I deserve this” justification for splurging to the “it wonāt happen to me” attitude towards insurance, our brains have all sorts of natural blind spots that impact our finances.
The good news is, learning about these biases and cognitive quirks might help you recognize future bad decisions and help you pivot before you make them.
Hereās a list of these cloaked biases and examples of how they can sabotage your financial game.
Status quo bias
Humans donāt like change. In fact, we dislike it so much, sometimes we stay with our current methods or activities even when we know full well that a better or cheaper alternative is available!
This is because of status quo bias, also known as default bias. Itās our ānatural tendency to hold to the current situation rather than any alternative situationā.
A few real life examples in personal finance:
- Staying with the same insurance policy, even though you know there are cheaper options out there.
- Sticking with your bank (which you hate that charges you dumb junk fees) even though more modern banks and apps are available.
- Continuing to pay Verizon or AT&T $70 per month for cell service when much cheaper carriers exist at literally HALF the price.
Itās not because switching methods is actually that difficult. It only takes probably ~1 hour of work to lock in multiple hundreds of dollars in recurring annual savings.
Itās more the fear of the unknown that scares us. We overestimate the bad things that might happen and grossly underestimate the benefits of trying new things.
Sooooā¦. How can you avoid falling into the status quo trap?
First, read the book Who Moved My Cheese. Itāll change the way you think about change.
Next, when evaluating changes that involve financial savings, think long term. Saving $45 a month doesnāt seem like much. But over a 30 year period (invested and compounded) weāre talking about 88,826!
Worth switching now? You bet!
Lastly, when considering the downsides, truly assess whether the āworst thing that could happenā is actually that bad. Usually itās not.
For example, letās say you donāt want to switch cell providers because youāre worried about coverage issues. Well, on the off chance that happens, you can just switch back. Not really a life-ending scenario.
Restraint bias
Hereās why taking a trip to the mall to ājust look aroundā usually results in you buying something you didnāt intend toā¦
Restraint bias is āthe tendency for people to overestimate their ability to control impulsive behaviorā. Basically, we think we have more self control than we actually have in the face of temptation.
Impulse spending is a common example. We all know browsing on Amazon leads to buying crap you donāt need.
But restraint bias is also common in investing. People vastly overestimate their risk tolerance and ability to remain calm under pressure.
āIāll put 100% of my portfolio into stocks! I know itās volatile but Iām young and can stomach those massive swings. I wonāt be tempted to freak out or sell at allā…
6 months later, and a 20% downturnā¦ everyoneās jumping ship and taking massive losses!
Overcoming this bias isnāt terribly hard. You basically need to play things a little safer, and perhaps act a bit more modest.
Youāre not as strong willed as you think you are š¬
The IKEA effect
I find this paradigm suuuuper interestingā¦
The IKEA effect is āa cognitive bias in which consumers place a disproportionately high value on products they partially createdā
Basically, people happily overpay for furniture that they have to build themselves, because putting effort into something makes it feel more valuable.
How much more are people willing to pay?… A 2011 study found that on average people will pay 63% MORE for furniture they assembled themselves (compared to the exact same item someone else put together).
To put this into dollars, instead of buying a crappy $80 set of drawers at a cheap furniture store, people would rather pay $130 for those exact same crappy drawers, then spend 1-2 hours putting them together.
Kind of silly, right!?
Effort justification bias
Itās not just IKEA products and consumer goodsā¦ we glorify almost anything we put effort into personally.
Effort justification is āa person’s tendency to attribute greater value to an outcome if they had to put effort into achieving it.ā
Hereās an investing exampleā¦
Newbie investors might think the 24% ROI that Jenny made from flipping a house this year, is ābetterā than the 24% return Steve made from his S&P 500 index funds.
Even though the ROI is exactly the same, Jennyās performance is seen as worth more because she worked harder for it.
We naturally glorify people that make their money in hard ways vs. people that make it in easy ways.
Now that youāre aware of this bias, here are a few things to keep in mind:
- Money is money, no matter the sourceā¦ Treat your $2,000 tax return the same as the $2,000 you earned side hustling.
- Donāt ātinkerā with your portfolio. It might feel good being āhands onā with trading stocks or moving money around. But the truth is passive investing trumps active investing.
- Stop overpaying for subpar furniture at IKEA!
Frequency illusion bias
You know how when you buy a new car, you suddenly see that exact same make/model EVERYWHERE the next few months? š
This is because of the frequency illusion. Itās a mind trick where āa person notices a specific concept, word, or product more frequently after recently becoming aware of it.ā
This bias isnāt inherently bad. But when itās mixed with FOMO, it can lead to some really dumb money choices.
Some examples:
- āMary showed me her gorgeous new handbag last week, and Iāve seen like 50 other girls with one since. I better buy one ASAP.ā
- āI just learned about investing in carbon credits. Itās all over my newsfeed and I just started noticing how much pollution big factories actually put out. I better invest so I donāt miss out on this killer opportunityā
- āALL my friends are buying houses right now. Iām financially doomed because I donāt own a houseā
Social media only amplifies the issue. TikTok, Instagram, etc. all use pattern recognition to show people the same crap again and again in their newsfeeds.
It creates the illusion that the entire world thinks xyz is important, when in reality itās only important in your world.
Just knowing about the frequency illusion bias is the first step towards combating it. Taking a break from social media (or all technology) will help bring you back to reality.
Related: Tips to avoid financial FOMO
Hyperbolic discounting bias
If you had the choice between receiving $100 right now or getting $150 six months from now, which would you choose?
Most people would take the $100 upfront! Six months is too long to wait for that extra $50.
Hereās an interesting plot twist thoughā¦
What about if the choices were: Receiving $100 one year from now, or getting $150 eighteen months from now? Which would you choose?
Most people would choose the bigger amount, $150. Suddenly waiting an extra six months seems worth it for that extra $50.
Hyperbolic discounting is the ātendency for people to have a stronger preference for more immediate payoffs relative to later payoffs.ā
Humans struggle with delayed gratification. This is well known. Itās one of the main reasons people live paycheck to paycheck and donāt invest for the future.
But, when the time frames are shifted (and the immediate gratification option is removed) we suddenly think a little clearer. Less emotional. Less about our present self and more in the shoes of our future self.
Escalation of commitment
Youāve probably heard of the sunk cost fallacy. Where people continue to sink time, effort or money into something they know isnāt good for them.
Cutting losses and accepting failure is extremely hard.
Well, escalation of commitment is pretty much the same thing. But I like this term better, because it describes how the problem escalates with more time/effort/money being sunk. š
True story: One of my friends in 2014 pulled all his investments out of the stock market. He was convinced a big crash was coming.
Two years later in 2016, he knew he made the wrong choice because the stock market didn’t crash. It actually went up! But he stuck to his guns and decided not to invest ā waiting for an inevitable crash.
Two more years went by. Now it was 2018 and he was CONVINCED a crash was around the corner.
By the time 2020 arrived and there actually was a market crash, he was so ingrained in the belief that there was more downside to come, that he still didnāt invest.
Itās now 2024 and I don’t think heāll ever swallow his pride and just start investing. His commitment to āwaitingā has escalated to the point he may live in poverty for the rest of his life.
Cut your losses, people! Instead of worrying about past decisions and feelings, focus on the future upside and expected results.
Fail fast, fail often. Itās far easier to course correct after minor mistakes than it is after longer and deeper ones.
Disposition effect
Very similar to the bias above, this one also plays on our natural tendency for loss aversion.
The disposition effect is: āthe tendency to sell an asset that has accumulated in value, and resist selling an asset that has declined in valueā
Basically, we get rid of winners, and hang onto losers. (the opposite of what we should actually do)
Stock picking and day trading is one of the quickest ways to go broke. If youāve tried it, you already know what I mean. š As humans, we are hard-wired to make the wrong timing decisions.
Thatās the beauty of buying index funds. You never have to worry about which stocks to hang onto and which ones to sell. When you own them ALL, the total sum of winners outperforms the total sum of losers.
In rental property investing, I see the disposition effect a lot, too. Landlords sell their profitable rentals and hang onto the headaches.
It should be the opposite. Cherry pick the best properties with highest cash flow and fewest time sucks, and get rid of the rest.
Neglect of probability
Simply put, humans are really bad at grasping probability. Especially when it comes to āemotion-arousingā outcomes (which is basically anything money-related!)
Would you rather a 1 in 1,000 chance of winning $10,000ā¦. Or a 1 in 300 million chance of winning $300 million?
Most humans would choose the second option, focusing on the size of the prize. But the smarter choice is having a higher probability with the first option!
In the case of investing, humans chase higher returns with way less probability of success. They completely disregard math and common sense, and instead try to get lucky.
A few specific examples:
- Crypto gambling: Instead of investing in a 401k with a guaranteed company match and an immediate tax benefit, Connor is betting on an unknown cryptocurrency, hoping to become a millionaire.
- Risky stocks: Jane invests in a highly speculative penny stock with a tiny chance of massive returns, rather than diversified index funds with a much higher probability of steady growth.
- Timing the market: Sonia tries to predict market tops and bottoms for short-term gains, rather than adopting a long-term, consistent investment strategy with higher odds of success.
Probability and possibility are two very different beasts! Donāt confuse the two.
Hot-hand fallacy
The hot hand fallacy is āthe belief that a person who has experienced success with a random event has a greater chance of further success in additional attempts.ā
In 2020, Cathie Wood’s ARKK (ARK Innovation ETF) fund experienced killer growth, gaining about 150% and significantly outperforming the broader market.
This stellar performance attracted a wave of new investors in early 2021, many of whom believed Wood had a “hot hand” in selecting innovative stocks.
Fueled by this confidence, they poured money into ARKK and ignored important investment principles like diversification.
As 2021 progressed, ARKK’s fortunes changed dramatically. The fund’s value plummeted, losing about 67% from its peak by the end of 2022. Its top holdings of Tesla and Zoom faced mammoth declines.
Jumping on winning streaks and following hot hands usually ends in tragedy. It causes you to buy high and sell low.
Instead, just continue with the basic, boring investment principles. Good times come to and end, and slumps too shall pass.
Gambler’s fallacy
If you flip a coin and land on heads 5 times in a row, what are the chances the next flip will land on tails?
Most people think landing on tails is almost certain. I mean, getting heads 5 times in a row is crazy, so 6 would be ridiculous!
But the truth is thereās still a 50/50 chance it will land on heads again. Every flip has an individual 50/50 chance of heads/tails.
The gamblerās fallacy is āthe tendency to think that future probabilities are altered by past events, when in reality they are unchanged.ā
Hereās an example when thinking about insurance:
Someone might cancel their homeowners insurance policy because they havenāt had to make a claim in decades. They believe they’re less likely to need it in the future.
But the odds of a disaster happening have not changed. Theyāre exactly the same as they have always been. Insurable events are random in nature, no matter what has happened in the past.
Moral credential effect
I used to work at McDonaldās. It always puzzled me when people would order a ādiet cokeā to go with their greasy, 1000 calorie Big Mac combo.
They felt good about taking the healthier soda option, as if it offset the negative attributes of the fatty and horrible meal theyāre about to wolf down.
The moral credential effect (aka self-licensing) occurs when āsomeone who does something good ā gives themselves permission to be less good in the future.ā
A few examples related to money choices:
- Splurging after budgeting: āIāve been so good in cutting back on my daily Starbucks trips, Iām going to celebrate by taking a 5-day vacation to Franceā
- Luxury purchases after being frugal: āIāve had the same trashy old car for 10 years, so I deserve a brand new Audi next time.
- Justifying unnecessary buys: āAlthough I donāt really need a new TV, Iām being good because Iām buying the less expensive version. Plus, I’m using a coupon so, winning!ā
Iām not saying that itās a bad idea to treat yourself in little ways along your financial journey. You definitely should!
Just make sure the splurge doesnāt totally negate the progress youāve made!
Proportionality bias
This next bias explains why we ignore the little things that compound and only focus on the bigger money moves.
Proportionality bias is: āour innate tendency to assume that big events have big causesā
Itās easy to assume that John is a millionaire because he inherited a ton of money from family.
Nope! John is actually a millionaire because he put a measly $450 from every paycheck into his 401k for the last 25 years.
No big life-changing event. Just tiny and consistent savings.
Everyday people wake up wondering, āhow do I have 45k in credit card debt?! I donāt even own anything very expensive!?ā
Well, youāve grossly underestimated the sum of all the small things. And the sneaky reality of compound interest over time.
If you havenāt read the book The Compound Effect, add it to your list!
Bandwagon effect
Jim Rohn says: You become the average of the five people you spend the most time with.
Ain’t that the truth!
The bandwagon effect is āthe tendency to do (or believe) things because many other people do (or believe) the same. Itās related to groupthink and herd behavior.ā
Going to college, getting married, buying a house and having kids is the norm. In that exact order.
But is this the right path for you? Do you want all that stuff because itās your dream, or are you chasing what everyone else seems to want in life?
Hanging around with positive influences has a huge effect on your money situation.
If you hang out with big spenders, you will naturally spend more. But if you befriend folks with frugal habits, you will adopt some of those money saving tendencies.
Bottom line: Be careful who you hang around! (And which influencers you follow online!)
Spotlight effect
Last but not leastā¦
The spotlight effect is āthe tendency to overestimate the amount that other people notice one’s appearance or behaviorā
Seriously, the only person that cares about you wearing those $800 sunglasses is YOU. Strangers may take brief notice, but they donāt care as much as you think they do.
Driving a luxury car and wearing designer outfits isnāt actually all that impressive these days anyway. Itās the sign of a person who has spent lots of money and probably has none left.
You know what is impressive these days? Stealth wealth. Itās about living a well rounded, wealthy life, with more free time and riches. You canāt wear it on your wrist, but itās ridiculously freeing.
The Bottom Line:
Now that you better understand some of these cognitive biases like the hot hand fallacy, gambler’s fallacy, and IKEA effect, etc. how can this info help you make better money decisions going forward?
Being good at personal finance and investing is less about making all the right money moves, and more about doing less of the massively detrimental stuff.
Ultimately, by being aware of these biases and actively working to counteract them, you can improve your money game and avoid those common financial traps!
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