How Cognitive Biases Affect Your Financial Habits
Ever wondered why you sometimes make financial decisions that you later regret? Maybe you splurged on something you didn’t need or avoided investing in something that could have grown your wealth. These behaviours might not just be bad habits—they could be influenced by cognitive biases, the mental shortcuts our brains use to process information.
Cognitive biases are fascinating because they’re universal. Everyone has them, and they’re often unconscious. But when it comes to money, these biases can sabotage your financial goals. Let’s dive into some of the most common cognitive biases that affect your financial habits and explore how you can overcome them.
Table of Contents
The Anchoring Effect: Getting Stuck on Irrelevant Numbers
Imagine you’re shopping for a car, and the first price you see is £40,000. Even if you end up negotiating the price down, your brain is “anchored” to that initial number, making a £35,000 price tag feel like a bargain—even if the car’s market value is closer to £30,000.
Anchoring happens when we rely too heavily on the first piece of information we encounter. In financial decisions, this can lead to overpaying or setting unrealistic expectations.
How to avoid it:
Research thoroughly before making big purchases or investments.
Compare multiple options to get a more objective view.
Remind yourself that the first number you see is often arbitrary.
Loss Aversion: Fear of Losing Trumps the Joy of Gaining
Studies show that people feel the pain of losing money about twice as strongly as the pleasure of gaining an equivalent amount. This bias, known as loss aversion, can make you overly cautious, preventing you from taking calculated risks like investing in the stock market.
For example, you might hoard cash in a savings account instead of investing, even though inflation is eroding its value over time.
How to avoid it:
Focus on the long-term benefits rather than short-term fluctuations.
Diversify your investments to minimize risk while still growing your wealth.
Remind yourself that avoiding all risks can be just as costly as taking too many.
The Availability Heuristic: Letting Recent Events Skew Your Judgment
If you’ve heard about a friend losing money in the stock market, you might assume investing is inherently risky. Conversely, during a booming market, you might overestimate the chances of success. This is the availability heuristic at play—we tend to rely on recent or vivid examples when making decisions.
How to avoid it:
Look at long-term trends rather than isolated incidents.
Avoid basing decisions solely on headlines or anecdotes.
Consult credible sources or financial advisors for a balanced perspective.
The Bandwagon Effect: Following the Crowd
Remember the cryptocurrency craze when everyone seemed to be investing in Bitcoin? The bandwagon effect happens when we follow the crowd, assuming that “if everyone is doing it, it must be right.” While this bias can make us feel included, it’s often a recipe for financial mistakes.
How to avoid it:
Ask yourself: “Would I still make this decision if no one else was doing it?”
Stick to your financial plan and avoid getting swept up in trends.
Conduct your own research before jumping into any investment.
Hyperbolic Discounting: Prioritizing Instant Gratification
Why save for retirement when you could buy a new gadget today? Hyperbolic discounting is our tendency to prefer smaller, immediate rewards over larger, delayed ones. This bias often explains why people overspend or struggle to save.
How to avoid it:
Automate your savings and investments to make future-focused decisions easier.
Break long-term goals into smaller, more tangible milestones.
Reward yourself for hitting savings or investment targets to keep yourself motivated.
Confirmation Bias: Seeing What You Want to See
If you believe real estate is the best investment, you’re more likely to seek out information that confirms your belief and ignore evidence to the contrary. This is confirmation bias, and it can blind you to opportunities or risks.
How to avoid it:
Actively seek out opposing viewpoints.
Regularly review and question your financial strategies.
Stay open to learning and adapting as circumstances change.
Practical Tips to Outsmart Cognitive Biases
Track Your Financial Habits: Use a budgeting app or spreadsheet to understand where your money is going. Awareness is the first step to change.
Set Clear Goals: Define your financial objectives, such as saving for a home or retiring early, and revisit them regularly to stay focused.
Build a Decision-Making Framework: Before making financial decisions, ask yourself:
What is my goal?
What are the risks and benefits?
Am I being influenced by emotions or biases?
Consult Experts: Sometimes an outside perspective can help you see through your biases. Financial advisors or even a trusted friend can offer valuable insights.
Keep Learning: Financial literacy is a powerful tool. The more you understand about money and investing, the less likely you are to fall prey to biases.
Simply Put
Cognitive biases are a natural part of being human, but they don’t have to control your financial life. By recognizing these mental shortcuts and actively working to counteract them, you can make smarter, more deliberate financial choices. Remember, the goal isn’t perfection—it’s progress. Every small step you take to outsmart your biases is a step toward financial freedom.
