We all have biases–cognitive and emotional– that may cloud our judgment when making day-to-day decisions, especially about our finances. We often depend on our intuition, but sometimes we are unaware of how our gut feeling may be faulty.
These biases affect how we think, act, and make purchases against our better judgment.
Learning how these biases work is a first step to guarding ourselves against becoming irrational when managing money when we want to save, be more rational shoppers, and invest.
Table of Contents
What Are These Biases?
Biases are either cognitive or emotional that can lead us astray. They create behavioral patterns that may interfere with our financial goals. Our decision-making may be faulty when cognitive biases interfere.
On the other hand, emotional biases are distortions in cognition, but emotional factors may lead to poor decisions. Emotional biases are ingrained in our brains and may be harder to overcome than cognitive biases. Marketers exploit these behavioral psychology traits to get us to spend more and buy impulsively.
Common Biases We Need To Overcome
1. Anchoring Bias
When shopping, anchoring, a cognitive bias occurs when we place a lot of value in the first information we get. We often rely on the listed price when we make price comparisons. For example, seeing priced T-shirts that cost $700 in one store and another one that is $200 will cause the latter shirt to look cheap. The higher cost is your anchor price. Retailers often use a higher list price for coats on “sale” at $1,000 with a 75% markdown to $250. Now, that coat’s a bargain, but it may not necessarily be so.
“I am not paying the retail price!”
I often shop with a friend, Sue. She will never pay the full or retail price for anything. As a result, Sue feels great walking out of a store, her hands full of marked-down items by various percentages.
The problem is that many retailers know that jacking up their list price to an unrealistic level with a beaming sale price will get shoppers’ attention and play to their beliefs that they got a bargain. It may not be so. Do your research and know the merchant’s sales strategies as well as the quality you are getting. Getting false deals is a real let-down.
Bob’s Furniture Store has a different strategy. There are no sales or ability to negotiate a lower price for their furniture. The list price is what you pay, period. We recently looked at several furniture stores before we ended up buying our children’s furniture there. While other merchants used anchor strategies, their marked down prices were either the same or higher, often for less quality.
Anchoring comes into play in various ways, such as negotiating your salary, a car loan, or getting a savings account. On the latter, you may get a higher annual percentage yield (APY) on your savings account than other banks, but it may charge higher fees. Know all of the specifics of the deal and compare it to other offerings to increase your savviness.
2. Choice Supportive Bias
Sometimes referred to as buyer’s remorse after making a particular purchase, choice supportive bias helps us to justify that discomfort we may feel postpurchase. Sometimes this is called cognitive dissonance. Ever experience regrets after making an expensive purchase? I have had that feeling which is sometimes akin to guilt or doubt about the decision. We want to convince ourselves we made the right choice. Increasingly, marketers recognize this tendency and work hard to provide postpurchase customer service by welcoming you to that merchant and asking if you need any help with the product.
Choice supportive bias changes what we remember about our decision. We distort our memories about our choices, ascribing more positive traits to justify our selection better. In a selective distortion 2000 study by Mathers, Shafir, and Johnson in 2000, the participants chose two job candidates. Each candidate had positive and negative attributes. Later, the subjects remembered their preferred candidate’s better aspects.
Rather than twist our thoughts around, we should make better choices in the first place. Evaluate your alternatives and review return policies before making your final decision. This way, you maintain your control over buying decisions. We can reduce our spending by becoming better shoppers.
3. Confirmation Bias
“I never allow myself to hold an opinion on anything that I don’t know the other side’s argument better than they do.” Charlie Munger
If choice supportive bias is selective distortion, confirmation bias is about selective attention. People will remember information selectively, interpreting data to support their existing beliefs, even if the evidence is ambiguous. We tend to agree with people who seem to conform to our ideas. Alternatively, we are dismissive of new information even if that provides evidence that is wrong but accurate. Sometimes we skim or not read all of an article or report.
I sometimes see my students do this in their term papers. For example, when looking to support their views, I will see only one part of the argument presented rather than writing about the opposite point of view they are encouraged to know. News from social media often reinforces one side of a debate. That tendency is pervasive and used to protect our egos from thinking we may be wrong.
This bias may hurt our abilities when making financial decisions. For example, if you are truly open to deciding between renting or buying your home, you should want to know both sides of each decision. There are pros and cons to every decision we make. Confirmation bias works when we may have a preference. We may only focus on the relevant information for your choice. However, you should always do research and know both sides of an argument.
Talluria Study On Dots
Talluria et al. study highlighted a confirmation bias based on experiments that seek consistency across different stimuli. In this case, the researchers asked the participants to view two successive movies featuring a cloud of small dots moving on a white computer screen. They reported on the direction of the moving dots after the first movie. They did the same, that is, report on the path of the dots after the second movie.
The Talluria et al. study proved that people would hold the same confirmation bias even if they are making choices (i.e., dot pathways) that are far less consequential than financial decisions.
4. “Bandwagon” Effect
The majority of us fall for the bandwagon effect whether we consciously know it or not. The bandwagon effect (or jumping on the bandwagon) occurs when people mimic other people’s buying choices. For marketers, this phenomenon, when triggered, can propel the popularity of a certain product or service into a grand slam.
This psychological trait influences consumer behavior even when the product has features we don’t need. Think about those who bought 4K TVs when most broadcasts and hardware didn’t support those resolutions. Even today, people will stand in line (especially if it is a long one) for the latest iPhone release to buy the latest dual-camera offering. Are they better than the single-camera? People will also switch to a winning candidate than sticking with their choice. Groupthink happens in fashion, music, politics, and restaurants. Social media amplifies this cognitive bias.
When IPOs Are “Hot” And Sometimes Not
This happens a lot in the financial markets, incredibly when pricing the initial public offerings (IPOs). On their first day of trading, these stocks average 20% rises or higher. Beyond Meat, which makes vegetarian burgers and sausages began trading at $25 a share, ending the day at $65.75. This was among the most significant first-day pops of recent IPOs. This stock continued its rise months afterward.
However, many stocks ultimately flop after the first day’s rise, such as Blue Apron and Snap. Investors clamored for Facebook’s IPO, which immediately rose after it began trading. However, it fell back to its IPO price of $38 at the day’s close and had dropped below $18 in a few months. Yet, investors who aren’t able to buy at the IPO price may flock into the market, jumping on the exciting bandwagon after the new stocks begin trading, only to be disappointed later on. Warren Buffett, among the best investors of all time and a proud contrarian, says, “Be fearful when others are greedy and greedy when others are fearful.“
5. Framing Effect
We often make decisions influenced by the presentation of information. Is the glass half-full or half-empty? Risky situations use framing. For example, when characterizing a rescue mission, saving 90 out of 100 people sounds better than losing ten people out of 100 people. When seeing sales signs, people are attracted to bigger percentages (25% as compared to 1%) as significant savings. For example, a lamp that sells for $40 has a 25% discount or $10 off. It might be worth the ten minutes drive to the store. On the other hand, if a $1,000 couch is marked down $10 or a 1% discount, we may consider this worth the trip.
Amos Twersky and Daniel Kahneman did a lot of research on framing risk. People generally avoid risk when presenting a positive frame. In their 1981 study, when presented positively, treatment A was chosen by 72% of people affected by a deadly disease. When presented negatively, only 22% of people selected it.
6. Ostrich Effect
Ever want to avoid bad news? You start to distract yourself with nonsense work, putting your head in the sand like an ostrich. I have done this more times than I would like to admit. It sometimes occurs when you are holding stock and you ignore bad news a company has released like missing their earnings target. Rather than sell the stock, I may delay making a decision. This is a form of selective attention. We may be missing information that proves to be an opportunity.
Coined by Galai & Sade in their 2006 study, the ostrich effect means “avoidance of apparently risky financial situations by pretending it doesn’t exist.” Karlsson, Lowenstein & Seppi in their 2009 Scandinavian study, found that investors checked their investment portfolio’s value 50% to 80% less in weak markets. While we don’t want to know negative news, it could be beneficial. However, investment experts point out that imperfect markets could be huge buying opportunities. For those who were fully invested in the market, it could be good news to pick up beaten-down stocks if fundamentals are alright.
Avoiding what we need to do may cause us to miss deadlines such as opting in our company’s sponsored retirement plan or dealing with credit card debt getting to dangerous levels. Avoidance is somewhat akin to being a procrastinator as an easier path over making decisions in the short term. Longer-term, matters get worse with inaction. Be proactive over significant decisions in your financial life.
7. Overconfidence Bias Aka Dunning-Kruger Effect
Ever sit next to someone at a holiday gathering when that someone is spouting about a topic, holding everyone’s attention, and speaking confidently? You may admire that person for their intelligence at first. Later, you may realize that it is not so. This bias is when people believe they are smarter and more capable but they do not have the self-awareness to recognize it. They hold overly favorable views of themselves.
In the early days of attending law school, I noticed sometimes with envy that there were a few students who raised their hands constantly answering questions with zest. However, the professors didn’t seem too enthusiastic about their explanations. Over the next few months, these same students I thought were among the brightest quit law school, apparently flunking out.
In a Dunning & Kruger study testing humor, grammar, and logic, participants scored in the 12th percentile but estimated that they were in the 62nd percentile, overinflating their skills. They found that those with overconfidence aren’t necessarily embarrassed to learn differently because they hold strong views.
Overconfidence can get in the way of digging deeper into a topic whether at work or at school. You may truly believe that you know a lot in a certain area but your boss isn’t impressed and wants a full report on his or her desk.
Know What You Don’t Know
To combat this tendency, know what you don’t know. Exhaustively researching a critical subject doesn’t mean reading some articles online. Social media provides snippets of information and may convince you to see a lot. Dig deeper and explore beyond the superficial layers that you first. It takes more energy but it may get you to a better draft.
As a professor, I experience this often with some students. When searching for corroborative articles to support their thesis, they may say, “I looked everywhere and only found this one article.” They were sure they sifted through all the relevant articles. When they visit me in my office, we will search together using a number of different keywords. Over a relatively short period, we have gathered some more meaningful reports for their project after checking more ways.
8. Endowment Effect Aka Status Quo Bias
What you own or use is “the devil you know.” This bias refers to our preference for the current state of affairs. Making changes can be difficult. Data shows that switching jobs at the right time can be a smart move if it helps to maximize income. Yet, many of us resist even exploring the opportunity because of the switching costs like having to work with different bosses, co-workers, benefits, and systems we don’t yet know.
Status quo bias arises when we consider going to a different doctor, brand, or hair salon even if they charge better prices. We may even hold onto to a “losing” stock rather than sell it because we are continually expecting a turnaround that may never come. Status quo is similar to loss-aversion bias which says that what you own is more valuable.
Wine Values That Appreciate
Kahneman et al write in a 1991 study about a gentleman known to have gotten several good Bordeaux wine bottles at low prices. The gentleman learned that the wine much appreciated from its $10 cost per bottle. It would fetch $200 at auction. Although enjoying this wine on occasion, this man would neither sell at auction nor buy at $200. This pattern reflects the fact that people often demand much more to give up an object than they would be willing to pay for it. According to our status quo bias, it suits us to hold onto this object we value, be it land, wine, or jewelry rather than part with it.
Sometimes, we may stay too long in a far more risky portfolio we bought when we were younger and without children. While it was appropriate then, reconsideration of your current lifestyle now is essential. Speaking to a financial advisor at different stages of your life may help you to realize that you should be modifying your investments. Your children may be approaching college years as you should be thinking about your retirement planning. Diversification and risk allocation should be reviewed by you annually and conformed to your life stage and appetite for risk.
Automate Where Possible
Overcome this inertia by planning. If you recognize that you have this tendency of paralysis and not making changes, automate your bill payments and automatically enroll in the retirement plan at work if this is available. Consider target rate funds when investing. These funds automatically reallocate your investments based on changes in your age and risk tolerance. When you start a new business, plan for an exit strategy if things don’t work out rather than losing money if success is not in sight.
Klontz Study On Personal Savings
In a recent study called The Sentimental Savings Study, Dr. Brad Klontz used financial psychology to increase personal savings. The study compared financial psychology sessions and financial educations sessions.
There were 102 subjects who participated in three stages: pre-session, post-session, and a follow-up. After the session, the group that received the financial psychology session showed statistically significant increases in their readiness to save, confidence in their financial abilities, and satisfaction. At their 3rd week follow-up, the financial psychology group reported a 73% increase in their savings versus a 22% increase for the other group. As Dr. Klontz proved, those who tend towards status quo bias, need a nudge to automate payments to enhance savings opportunities directly from paychecks.
9. Present Bias And Procrastination
This bias values the present when we are planning for the future. We procrastinate rather than thinking ahead to our detriment. It affects our health, including our financial well-being. If we favor the present, we won’t delay gratification. Instant gratification suggests that some of us shop impulsively, ringing up unreasonable bills and saving less than we should. Stephan Meier’s study in 2010 found present-bias minded individuals are more likely to borrow and accumulate higher balances on credit cards.
10. Sunk Cost Fallacy
The feeling of throwing good money after bad arises in many investment situations. A sunk cost is a cost that has already been spent and permanently gone. You don’t have it in your budget. If you are running a business, there are certain fixed costs, like salaries you have to pay. If you are renting your apartment, it is your monthly bill for the benefit of living there for time of the lease.
Examples of Sunk Cost Fallacy
Sunk cost fallacy is a negative mindset when you are honoring the sunk costs you already invested. For example, you bought paint buckets for your home. After painting a part of your living room, you realize that you hate it. However, you spent a lot of money thus far so you may as well use it. This is probably not a good idea. You can return the unused cans and start over rather than be miserable. The cans already used are sunk costs, but the fallacy is when you go forward with the paint you don’t like anyway.
I sometimes stay too long with a book I am not enjoying. Other than losing time, it doesn’t feel like too much of a mistake especially if I find redeeming values at the story’s end. On the other hand, holding onto a stock well after it has become clear that the company’s best days are long gone is an example of sunk cost fallacy. Use the long-term capital loss to reduce your tax bill instead.
Don’t Make Bad Decisions Worse
Continuing to pursue an option that no longer makes sense is a waste of your time and money. Buying tickets to a show you are no longer interested in may not be the best way to spend valuable time. Consider giving them to a friend who may enjoy the show or at least the gesture. Time is more valuable than money especially when it is limited.
A common way to experience sunk cost fallacy is investing money into a home that is too small for your growing family. If you love the house, it may be worthwhile to get estimates and consider expansion. On the other hand, if you are continuously are putting money into your home to fix it to your liking (and it’s becoming The Money Pit), it may time to search for a new home.
Recognize that small losses will become bigger losses if you continue to spend or invest money you are no longer supporting. By continuing down the road, you are making a bad decision worse. Learn how to cut losses and consider that amount in the past.
11. The Halo Effect
Ever find yourself prone to first impressions even in the face of adverse news. Many of us consider those early beliefs important, whether it is visiting a new store or website or buying a new brand. Marketers know this and tell their companies that they have to get things right the first time a potential customer sees the new product.
Tesla’s Elon Musk counts on that first impression although his recent flawed presentation of the futuristic Cybertruck when the windows broke reasonably quickly despite being touted as bulletproof. It may yet be a hit as Tesla and Musk have that halo effect that many CEOs envy. Early buying of the truck seems promising.
12. Denomination Effect
This bias refers to currency and our penchant to hold onto bills with big dollar amounts such as $100 rather than spending it. In the Journal of Consumer Research in December 2009, Priya Raghubir & Joydeep Srivastava found that consumers like spending smaller denominated bills ($20) while holding onto to larger denominations they received as a means to control spending. The lower spending power of the lower denominated bill was preferable.
As humans, we have biases that create blind spots in our lives. Recognizing biases often impacted by biases is a big part of the battle. We can outsmart these tendencies.
Many biases are promoted by marketers using behavioral psychology to call our attention to what they want us to see. Instead, take back control of your thoughts and decisions. Be proactive, make plans to counter these biases whether it spending more rationally, knowing the specifics of a deal, and automating retirement savings and investments for your financial future.
Thank you for reading!
Did you recognize any biases you have? How do you overcome these tendencies to get more done than you would prefer? We would love to hear from you! Please subscribe to our blog and find more articles like this.
With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.