We all like to think of ourselves as rational consumers. When we buyProduct A instead of Product B, we thinkwe’re doing it because we’ve carefully weighed the pros and cons – price, quality, and so on – and decided Product A is a better value. And if someone asked us why we made thischoice, no doubt we could list off a set of reasons that would seemperfectly sound.
But the truth is, sometimes we buyfor reasons that have nothing to do with the product. Our brains can trick us into making choices that seem logical, but don’t stand up to close inspection. These mental traps are called “cognitive biases.”
Cognitive biases can seriously hurt your bottom line if you let them. Fortunately, by learninghow these biases work, you can put yourbrain on guard against them. Here’s a look at ten of the most common biases, and howto protect yourself from them.
1. Anchoring Bias
To show how this bias works, let’s play a guessing game. Do you think that the tallesttree in the world is taller or shorter than 1,000 feet? Either way,how tall do you think the tree is overall?
Unless you already know a lotabout trees, you probably guessed that the world’s tallest tree is somewhere close to 1,000 feet. Maybe you guessed it was taller or shorter – say, 1,500 feet total, or only 500 feet – but either way, your guess was affected by the first number you saw.
This is an example of the anchoring bias – relying too much on the first piece of information you get. Since the figure “1,000 feet” was all you had to go on, that number became your “anchor,” and your guess about the tree’s height wastied down by it.Without the number 1,000 to guide you, your guess might have been much higher or much lower. (In case you’re curious, the actual answer is379feet.)
How This BiasCosts You Money
The anchoring bias costs you money when it leads you to judge the price of an item based on the first price you saw. For instance, suppose you’re shopping for atablet computer. You check thesale flyer for a local department store and see onemodel marked down from $500 to just $150.
That sounds like an amazing price, but only because you’re comparing it tothe $500 anchorprice. If you shopped around forsimilar tablets and found that most cost$150or less, it wouldn’t look like such a bargain. In fact, many stores raise their “regular” prices right before Thanksgiving to make their Black Friday sales look more impressive.
Sellersknow all about this bias, and they use it to their advantage. For instance, somereal estate agents make sure the first house they show to a newbuyerisludicrously overpriced. Compared to that, every other house on the marketwill look like a great deal.
Anchoring can also hurt you when you negotiate your salary. During a job interview, if you’re offered a starting salary of $25,000, you’ll probably hesitate to ask for $50,000, even if that’s what you think you’re worth. You couldend up dropping your asking price to $35,000 because you don’t want tosoundunreasonable.
How to Beat This Bias
The best way to overcome the anchoring bias is to do more research. That way you can replace that initial “anchor” number with other numbers that make more sense.
For example, if youwant to buy a house, check the “comps” – prices that comparable houses have sold for. That will let you know what’s really a fairprice to pay for the house you want.
Likewise, beforea job interview, do research on typical starting salaries. That way, when the boss names a number,you’ll know whether it’s a fair offer. Better still, turn anchoring to your advantage by being the first to name a salary. Then the boss will have to adjust to your expectations, instead of the other way around.
2. Bandwagon Effect
You’ve probably heard the phrase “jumping on the bandwagon.” It means going along with the crowd instead of making your own decisions. For instance, when fashions change, and suddenly everyone is wearing tight jeans instead of baggy ones, that’s the bandwagon effect.
To some extent, everybody does this. For instance, if you’re a man, you probably wear pants instead of skirts, because that’s what most men do. If you chose to wear a skirt, you’d be making yourself stand out on purpose.It’s perfectly normal forsocial standards to affect the way we dress, talk, and act.
But sometimes, we follow the crowd even when we don’t need to. We oftenchoosethe brands we buy, the music we listen to, or even the candidates we vote for because others doing the same thing. These choices aren’t required, and in some cases, they can be harmful.
How This BiasCosts You Money
The bandwagon effect can lead you tobuy products that aren’t the best value simply because they’re popular. Cell phones are a good example. If everyone you know owns the latestiPhone, you may assume that you need one too.
But maybe a different phone would be a better choice for you. Maybe you don’t need a smartphone at all. You could just be assuming you need one because you see everyone else carrying them.If you’re not getting real value out of having constant access to Facebook and stock quotes, that $90-a-month cell phone plan is just a waste of money.
The bandwagon effect can also lure you intounwise money decisions. For instance, you could take out a new car loan because “that’s just what people do.” You could save a lot of money by waiting tobuy a car with cashor buying a used carthat you can afford right now. But because of the bandwagon effect, those ideas might not be immediately obvious.
How to Beat This Bias
Going along with the crowd isn’t always the wrong thing to do. The real mistake is doing it without thinking. Maybe that new car or flashy iPhone really is the right choice for you. But you can’t know unless you think it through yourself.
Before you make any financial decision,do your research. This goes for both small choices, like buying a pair of shoes, and big ones, like investing your retirement savings. Look at all the options, do the math, and decide onthe best choice for you – not justwhat everyone else is doing.
3. Choice Supportive Bias
There’s nothing quite so frustrating as buyer’s remorse. It feels awful to look at something you just bought and realize it was a complete waste of money. In fact, we hate this feeling so much that we sometimes go out of our way to convince ourselves it wasn’t a waste at all. We come up with all kinds of arguments that we really did need it, and it was completely worth the money.
This kind of argument is calledchoice supportive bias. It applies to other decisions too, not just purchases. For instance, if youvoted for a candidate, you’re more likely to defend that person’s actionsin office. Letting yourself see that the person is doing a terrible job would force you to admit that you made a poor choice.
How This BiasCosts You Money
The problem is, when you defend a bad buying decision, you’re more likely to make that same decision again. To go back to our earlier example, suppose you’ve just bought a new iPhone. To make yourself feel good about this purchase, you focus on all the things you love about the new phone and ignore its downsides. When other friends show you their Android phones, you notice all the faults of these gadgets and not their benefits.
By the timeyou’re ready to replace the phone, you’ve completely convinced yourself thatiPhones are the best. You just upgrade to a new oneautomatically, without bothering to shop around. There could beanother phone out there that’s better and cheaper, but you won’t even consider it.
This bias can affect other financial choices too. For instance, suppose you’ve decided that you want to buy a house. Unfortunately, it’s a seller’s market right now, and most houses are way out of your budget. You’re probably better off renting for a while and waiting for prices to fall.
But you don’t want to hear this idea. You’ve already decided to buy, so youargue that renting is just throwing money away. You purchase a housethat you can’t afford, right before the market finally crashes. Now you’re stuck with an underwater mortgage and payments you can barely meet.
How to Beat This Bias
One way to get around thisbias is to treat each decision as a brand-new one. Don’t try to justify the choice you made last time. Instead, focus on making the best one now.
For instance, when it’s time to shop for a new phone, start completely from scratch, as if you’d never owned one before. Look at independent reviews that can give you the facts about which phone has the best features for the best price.
Also, remember that there’s often still time to reverse a poor decision. For example, the decision to buy a house isn’t final until you’ve signed the papers. So, if you see new information suggesting that you’re better off waiting a few years, pay attention to it. There’s no shame in changing your mind, especially when it can save you thousands of dollars.
4. Confirmation Bias
These days, many people like to gettheir news from socialmedia. They often setup feeds to deliver stories from their favorite sites – the ones that most reflect their point of view.
The problem with this is that the only news stories they hear are the ones they’re likely to agree with. Since everything they hear “in the news” supports their views, they get the idea that all the facts are on their side. Over time, they get more entrenched in their viewpoints because theynever hear the other side of the story.
This is a formof confirmation bias – the tendency to see onlythe facts that support our views.People who hold strong views on any subject, from global warming to the paleo diet, are at risk of blocking out any facts that go against those views.As a result, they can miss out on valuable information.
This bias often works alongside choice supportive bias. When we want to believe we’ve made the right choice, we seek out information that backs up that choice.
How This BiasCosts You Money
When you need to make a decision about money, it makes senseto research it carefully.By exploringthe subjectfrom every angle, you learn what you need to choose wisely. Unfortunately, confirmation bias makes it harder to do that.
For instance, suppose you want to start a small business. You go out searching for informationto find out whether this is a wise move. But since what you really want to hear is that you should go for it, you search for “reasons to start a business” rather than the “pros and cons of starting a business.” You end up seeing a lot ofarticles that tell you about the benefits of working for yourself, but none about the risks.
This hurts you in two ways. First, you’re more likely to take the plunge even if you’re not in a good position to do it. And second, you’ll be less prepared. Since you’ve read nothing about the drawbacks of running a business, you won’t know how to plan ahead to avoid them.
How to Beat This Bias
The best cure for confirmation bias is to open yourself up to more information. Make a point ofseeking out info that contradicts your viewpoints.
In fact, look for the strongestarguments you can find against the views you hold. Then balance those argumentsagainst what you already know, and see which side comes out stronger. If your views about money (or anything else) can’t stand up to this kind of scrutiny, they’re not worth holding.
5. Framing Effect
Time for another pop quiz. How do you feel about these two statements?
- People should be allowed to speak out publicly against democracy.
- The law should forbid people to speak out publicly against democracy.
Logically,the first statement is simply the opposite of the second. If you agree with one, you should disagree with the other.
But in an experiment described in the 1993 book “The Psychology of Judgment and Decision Making”by Scott Plous, people reacted differently to the two statements. Over 60% disagreed with the first one, but only 46% agreed with the second. In other words, people responded to the same idea differently based on how it waspresented. This bias is known as theframing effect.
How This BiasCosts You Money
To see how the framing effect can shape your money decisions,suppose yougo to a store to buy a couch that costs $1,000 and a lamp that costs $40. While you’re there, you learn that another store has the same lamp on salefor just $30. However, you have to drive 10 minutes to get there.
If you’re like most people, you’d say it’s worth the 10-minute drive to save $10 on the lamp. After all, that’s 25% of its cost. You’d hate to overpay for the lamp by that much.
But now suppose it’s the couch that’s on sale. By driving to the other store, you canget it for $990 instead of $1,000. To most people, it doesn’t seem worth making the trip for such a small savings. After all, it’s only 1% of the total cost.
The thing is, the amount you save is the same either way.The original priceshouldn’t matter; the only question is whether it’s worth driving 10 minutes to save $10. But when that $10 is a big percentage of the price,it looks like a bigger savings than it really is. Your brain tricks youinto thinking it’s worth the drive in one case and not in the other.
How to Beat This Bias
This doesn’t mean you should or shouldn’t drive 10 minutes for a $10 savings. That depends on a lot of things, such as how busy you are and how much gas costs. But it’s a decision you should make by looking objectively at the pros and cons. Other numbers, like the initial prices of the two items, are just distractions.
To beat the framing effect, take away the frame. In this case, that’s the original prices of the two items you’re buying.Set those aside and ask yourself: Is it worth driving 10 minutes to save $10?That will give you an answer that works for you, no matter what you’re buying.
6. OstrichEffect
Ostriches make nests for their eggs in the ground, and every so often, they stick their heads in to turn the eggs. This has led to the myth that these birds burytheir heads in the sandwhen they sense a threat. The idea is that rather than face a threat, they ignore it and hope it will go away.
Ostriches don’t really act this way, but humans often do. When we hear bad news, we block it out, as if ignoring the problem will make it disappear.
Procrastination is a common example of this.Say you have a big deadline coming up at work, and you still have a lot more to do on the project. Even though there are ways to stop procrastination, you don’t want to think about how hard the project is going to be, so you distract yourself with other things, like e-mail or tidying your desk.
This doesn’t make the deadline go away, of course. In fact, the longer you put off dealing with the project, the harder it gets to finish it on time. Ignoring the problemmakes it worse instead of better.
How This BiasCosts You Money
It’s easy tobury your head in response to financial problems. For instance, if you’re forced to find ways to reduce your credit card debt, looking at those huge bills is difficult. It feels much easier to toss the bills straight into the bin without even opening them.
Of course, doing this just makes the problem worse. For every bill you toss without paying, you pile extra interest and late fees on top of the balance you already owe.Also, the credit card company could jack up your interest rates, raising the balance evenhigher.
After a couple of months, you’ll start getting frequent calls from the bank, adding to your stress. Sooner or later, your creditwill be cut off completely, and you’ll still owe the huge balance.
How to Beat This Bias
Overcoming the ostrich effect isn’t easy. When your financial situation looks grim, it’s a lot easier to ignore it than to face the facts – even if you know, deep down, it will just make the problem worse in the long run.
For many people, one thing that helps is teaming up with others who are in the same boat. Support groups like Debtors Anonymous can help them recognize their shopping addiction as a problem they need to deal with.
Once they recognize the problem, they can start taking steps to conquer it. They can call the credit card company, admit they’re in trouble, and set up a payment plan to pay off those balances. Facing a tough problem this way is painful, but it’s the only way to make things better in the long run.
7. Overconfidence
Suppose you’re playing a simple coin-toss game. If the coin comes up heads, you win; if it’s tails, you lose. You can decide how much money to bet on each toss of the coin.
Since you know your chances of winning are only 50-50, you probably wouldn’t bet very high. But now suppose you suddenly hit a “streak,” tossingheads six or seventimes in a row. This long run of luck couldlure you into betting more. Seeingheads come up so many timescould make you feel moreconfident that it will keep happening – even though in your head, you know the chances haven’t changed.
If people can get overconfident about something as simple as a random coin toss, the problem iseven worsein a game that involves skill. For instance, when basketball players make a trickyshot, they’re more likely to assume they have the “hot hand” – that is, that they’re on a streak and can’t miss a basket. This leads them to attempt even riskier shots, which they’re more likely to miss.
How This BiasCosts You Money
If getting co*cky can hurt your score in basketball, it’s easy to see how much more damage it can do in the field of investing. For instance, if you put money into a stockand it takes off like a rocket, suddenly you think you’re a stock-picking genius. You ignore sensible, safe investments like index funds and instead start buyingindividual stocks, trusting in your imagined skills to find the right ones.
But even highly trainedexperts can’t identify the best stocks all the time, and amateurs certainly can’t. Sooner or later, you can be sure that one of your high-risk investmentswill tank. If your overconfidence led you to put all your savings into that one “hot” stock, you could end up with nothing.
How to Beat This Bias
Steven Dubner, one of the authors of the popular economics book “Freakonomics,” says the most important thing forinvestors to do is “acknowledge what you don’t know.”He saysmany wealthy people assume that if they’re smart enough to make a lot of money, they mustalso be smart enough to invest it.
But being an expert in one field doesn’t make you an expert in another.It makes more sense to hire a real expert to manage your money so you can focus on doing what you really can do well.
This holds true not just for investing, but for every kind of decision regarding your money. Whether you’re buying a TV set or choosing an insurance plan, it always pays to seekout expert guidance, even if you don’t think you need it.Consulting a few articles can teach you things about the subject that you didn’t know before. With help from the experts, you can make a truly confident choice.
8. Status Quo Bias
Humans are creatures of habit. We tend to stick with what we know, even when there are newer and better choices out there. We seeany change – a differentjob, a differenthome, even a differentpair of jeans – as a loss, and we resist it as long as we can.
Sometimes, even when we’re not happy with a part of our lives, we continue to cling to it. For example, suppose you’ve been going to the same dentistfor several years. Lately, you’ve started to have problems with your teeth – problems you think wouldn’t be so bad if the dentist had caught them sooner.
But when you think about changing dentists, you decide it’s not worth the bother. After all, you reason, you have no way of knowing if your problems are really the dentist’s fault. Besides, there’s no way to be sure another dentist would do better. But the real reason is that you don’t want to give up thedentist you know, even if you don’t like them very much.
How This BiasCosts You Money
Sticking to the status quo can be costly. Here are some examples:
- You stick with a name-brand product you’vebeen using for years, even though a private labelbrand would be cheaper and just as good.
- You keep an expensive cell phone plan that you’re used to, rather than switch to a cheaper cell phone planfor less than halfthe price.
- You hold on to a pricey cable subscription that youalmost never use, instead of switching to a cheaper streaming service.
- You keep the same investments in your 401kthat youhad when youfirst setup the plan, even ifyour financial situationhas changed.
- You leave money sitting in asavings account earning next to no interest, rather than get started investing in stocks.
How to Beat This Bias
Change can be scary. However, it’s usually easier if you start small. For instance, if you want to start using more store brands, don’t change all the products you buy at once. Instead, switchjust one product to the store brand, and onceyou get used to that, try another one.
Another way to overcome the status quo effect is to think aboutwhat you’d do if you had to make achoice starting from scratch. Lay out all the options, including the one you have now. Ask yourself which one you like best. If it’s not the one you have already, then you know it’s time to make a change.
9. Sunk-Cost Fallacy
Suppose you decide to take up tennis as a hobby, so you buy a racket and start taking lessons. After six months of practice, you’re not getting any better, and you really don’t enjoy it much. But you can’t give it up because that would mean all those hours you’ve spent on it would be wasted. So you keep struggling through lesson after lesson, hating it more and more.
In this story, you’ve fallen victim tothe sunk-cost fallacy, also known as “throwing good money after bad.” This means that you’ve spent money – or in this case, time – on something that turned out to be a bad investment. The smart choice would be to back outand cut your losses, but that would mean losing all the money you’ve already spent. So you keep pouring more “good” money into it, hoping to recapture the “bad” money that’s already lost.
How This BiasCosts You Money
The sunk-cost fallacy shows up most often in investing. Here’s one obvious example: youlendmoney to a friend to start a business. After six months,the honestly is struggling, and he hasn’t paid back any of yourloans.
Your friend convinces youthat he could get the business on its feet if he just had more cash. He asks for a second loan, which he promisesto pay, along with thefirst.There’s no good reason to believe him, but the only alternative is writing off themoney you’ve already given him. So you write another check, and you end up losing twice as much money when the business finally fails.
This fallacy can affect other money matters as well. For instance, suppose you’re trying to hire a caterer for your wedding. Youfind one whoseems okay and put down a $500 deposit. But then you find another who offers a menu you like even better at a much lower cost. However, switching to this caterer would mean losing your$500, so you stick with the first one, even ifswitching to the second would save you more than $500 overall.
How to Beat This Bias
The key to beating the sunk-cost fallacy is to recognize that what’s gone is gone.The onlyquestion that matters now is: which decision will costyou more going forward?
For instance, if you’ve given a $500 deposit to a caterer, that money is already spent, and you can’t get it back. But if switching to a different caterer can save you $1,000, then you still come out ahead, even with the $500 loss. In this case, the right choice is clear.
The first example – the loan for your friend’s business – is a little more complicated. If you think that an additional loan could save the business andpay off in the long run, then it couldbe the right choice. But you have to ask yourself if this will really work. If there’s only a 10% chance that more moneywill save the business, then you’re much more likely to lose the second loanthan to get the first one back.
In this case, it makes more sense to walk away. Even if it feels like you’re letting your friend down, the loan wouldn’t help him in the long run.He’sno better off putting another six months of his life into a failing business than you are putting more moneyinto it. By putting an end to it, you’re cutting his losses as well as your own.
10. Survivor Bias
Walking around the streets of an oldcity like Athens, you could easily get the idea that the buildersof the ancient world weremuch more skilledthan modern ones. After all, look at all these buildings still standing after thousands of years! What are the chances that any modern building will last that long?
You’re looking around at all the buildings that have survived, but you can’t see thecountless buildings that have long since crumbled to dust. Your view of the past is skewed because you’re seeing only its most spectacular successes.
This twisted view of the past is called survivor bias. It happens when you get an incomplete picture of a process because you’re seeing onlythe people or things that survived it.If you could see all the ones that didn’t survive, such as the ancient Greek buildings that are no longer standing, the picture would look very different.
How This BiasCosts You Money
The survivor bias often makes it harder to judge the performance of investments, such asmutual funds. Mutual fund companies tend to drop funds thatdon’t perform well, but when they measure the performance of their funds as a whole, they look only at the ones that have survived. This makes the company’s performance look stronger than it is becauseall of the weakest funds have been dropped from the records.
A study by Zero Alpha Group shows just how severe this problem is. This study looked at the performance of Morningstar mutual funds over the years from 1995 to 2004. It found that on average, dropping the weakest funds from the rolls boostedMorningstar’s apparent returnsby 1.3% per year.For the firm’s most aggressive funds, growth over the 10-year period appeareda whopping 116% lower with the droppedfunds added back in.
Survivor bias can also lead you astray when it comes tomaking careerdecisions.For instance, suppose you readan article on how to become a millionaire, and itsays most millionaires are small business owners. You conclude from this that the surest way to get rich is to start a small business of your own.
The problem is that the author of this article researched it by talking to a bunch of millionaires – people whose businesses had already succeeded in a big way. The article didn’t cover all the people who tried to start small businesses and ended up losing their shirts. It didn’t even look at the ones whose businesses are“successful” because they just manage to makeends meet every month. If you could look at all those stories, you might concludethat starting a business is theworst way to get rich.
How to Beat This Bias
One way to avoidthe survivor bias is to be wary of success stories. They’re often featured in magazines and online, but they only show you half the picture: what happened to the people who succeeded. To see the whole picture, you also need to know what happened to those who failed.
Whenyou heara success story of any kind, ask yourself what it’s leaving out. If you hear that 60% of allmillionaires owna business, flip that statistic on its headand ask what percentage of all businessowners becomemillionaires.Looking for the missing information will give you a more complete, realistic view.
Final Word
In manycases, the key to overcoming a bias is justknowing it’s there. For instance, if you know about the anchoring bias, you can take care not to put too much emphasis on the first number you see. In the same way, knowingabout the confirmation bias can encourage you to be open to other points of view.
The more aware you are of the tricks your brain can play onyou, thebetter you can be on your guard against them. Awareness is one of the best ways to save money on a tight budget.
In fact, sometimesyou can even usethese biasesto your advantage. For instance, you can make the status quo bias work for you by setting up an automatic savingsplan. Once you startputtinga portion of your paycheck into savingseach month, it will become part of your status quo – something you feel no need to change.
Have you ever experienced one of these biases in your daily life? What did you do to overcome it?
