Cognitive Biases and Money

In this topic, you'll learn:

• How thinking about money may affect decision making.
• How cognitive biases may undermine our financial goals.
• Ways to minimize the effects of unconscious biases.

We all want to believe we're rational decision-makers, especially when it comes to money. The truth is that our brains lean on mental shortcuts every day - shortcuts that can sometimes work against our financial goals.

Think of cognitive biases as predictable patterns of thinking that seem to make sense. But when you look deeper, they may not be rational at all. These biases are often "invisible" since they're simply part of how we perceive the world.

Six Cognitive Biases

When we fail to make good financial decisions, we often cast it in moral terms - blaming ourselves for lacking willpower or discipline. Yet, there may be much more going on beneath the surface.

Let's explore six common cognitive biases that can influence your financial choices - and the strategies you can use to recognize them.

Anchoring Bias

Anchoring occurs when you fixate on an initial piece of information - like the "original price" on a sale tag - and use it as a reference point for subsequent decisions.

If you see a $200 jacket marked down to $100, you might think it's a bargain - even if $100 is still more than you'd normally pay. The "$200" serves as an anchor, making the $100 price seem reasonable by comparison.

One of the problems with anchoring is that if the first bit of information is faulty, then all subsequent decisions are suspect. Consider salary negotiations - if the original offer is very low, any increase may feel like a big improvement, regardless of what the actual salary should be. Or say you're shopping for a wedding ring - if the first ring you're shown is ten times your budget, a ring that's just twice your budget suddently seems more reasonable.

How to overcome it: Do research before exposure to potential anchors. For major purchases or negotiations, determine your own value benchmarks first. When you see a sale price, ask yourself: "Would I pay this amount if it wasn't on sale?"

Present Bias (Immediate Gratification)

If someone offered you $1,000 today or $1,100 a week from today, which would you choose? What if someone offered you $1,000 today or $1,100 in one year? Present bias refers to our tendency to value immediate rewards over future benefits, even when waiting would be more rational.

Want to buy something but don't have the money? You may choose to buy it with a credit card and pay for it later - including substantial interest. What about saving for a long-term goal like retirement? It's easy to procrastinate, especially when saving for the future involves reducing today's spending money.

Immediate gratification is a powerful force in financial decisions. This bias helps explain why people struggle to save adequately for retirement despite knowing its importance.

How to overcome it: Create concrete visualizations of your future self. Research shows that people who feel connected to their future selves make more patient financial decisions. Automate savings and retirement contributions to bypass the temptation of immediate spending.

Confirmation Bias

Confirmation bias encourages you seek out information that aligns with what you already believe while ignoring contradictory evidence.

For example, suppose you've decided that buying a home is always better than renting. In that case, you might only pay attention to stories about successful homeowners while dismissing articles about the hidden costs of homeownership or the advantages of renting in certain markets.

This bias can be particularly dangerous for investors who become emotionally attached to their investment theses and ignore changing market conditions or new information.

How to overcome it: Deliberately seek out opposing viewpoints. Ask yourself, "What would someone who disagrees with me say?" For important financial decisions, create a list of potential reasons your initial judgment might be wrong.

The Endowment Effect and Sunk Cost Fallacy

The endowment effect makes us value things we already own more highly than identical items we don't own. Studies show people often demand much more money to sell something they own than they would be willing to pay to acquire the same item.

The sunk cost fallacy is closely related - continuing a behavior or endeavor due to previously invested resources (time, money, or effort). If you've ever heard the phrase "throwing good money after bad," then you're familiar with this bias.

Examples include favoring an investment you already own, even if it's underperforming other options, or continuing to pour money into a money-pit project because you've "already invested so much."

How to overcome it: Apply the "fresh start" test - ask yourself, "If I didn't already own this, would I buy it today at this price?" For ongoing projects or investments, focus on future costs and benefits rather than what you've already spent.

Loss Aversion

Researchers say losing $100 hurts more than gaining $100 feels good - about twice as much, in fact. That fear of loss can lead you to hold onto losing investments too long (because selling would confirm a loss) or avoid investing altogether because you can't stomach the idea of seeing your balance go down - even temporarily.

Loss aversion explains why many people prefer the certainty of low-yield savings accounts over potentially higher-return investments with some risk. The possibility of losing even a small amount of money feels more significant than the potential to gain much more.

How to overcome it: Reframe losses as part of a larger strategy rather than failures. Focus on total returns rather than individual positions. Consider setting predetermined exit points for investments to remove emotion from the decision to sell.

Overconfidence

Sometimes we believe we're better at something than we really are. Overconfidence might lead you to assume you can time the market or pick winning stocks without putting in the effort. It can also make you disregard the possibility of emergency expenses because "That'll never happen to me."

This bias can be particularly dangerous when investing. Studies consistently show that most active traders underperform the market, yet many individual investors believe they can beat the odds through skill alone. This bias often leads to excessive trading, increased costs, and, ultimately, lower returns.

How to overcome it: Keep a financial decision journal to track your predictions and outcomes. This step creates a record that's harder to misremember later.

The Takeaway

We've reviewed six powerful cognitive biases that affect financial decision-making, and there are many more - the bandwagon effect, hindsight bias, and availability bias, to name a few. But no matter what you call a particular cognitive bias, they all share the potential to hinder our ability to reach our financial goals.

Challenge yourself to pause before every money decision, big or small. Ask, "Which bias might be nudging me right now?" That simple question can work towards making decisions better aligned with your ultimate goals.