Heuristics & Biases (Part 1)
In the effort to be frugal and careful with our spending, we may often fall into cognitive biases that prevent us from spending our money wisely. The definition of a cognitive bias is an illogical pattern of thinking, and there are many of them that come up in regard to finances.
SUNK-COST FALLACY
When we don't switch actions to something better due to what we invested previously, we are the victims of a sunk-cost fallacy. Even though the money is gone and it's never coming back, people feel the need to keep going with an experience or work with less than ideal conditions because money was spent.
For example:
At a restaurant, customers keep eating the food they ordered even if they aren't hungry anymore.
A family may keep a piece of furniture that they don't need and doesn't match the house because it was an expensive piece.
I paid $80 for a bus ticket and then someone offered me a ride for $20, but I didn't take it because I'd have lost the $80.
Employees stay stuck in a job for years because they invested a lot of time in training.
Students insist on getting a job in the field they studied in even though it no longer interests them.
In each example, people are reluctant to take on a potentially better option or get rid of something extraneous simply because money was invested in it.
A study was done on travelers who accidentally booked two ski trips in one weekend. One was for $100 to Michigan and the other was for $50 to Wisconsin. The researchers told the participants that the Wisconsin trip was more interesting, but a majority chose to go to Michigan anyway. The thought of losing $100 was too scary.
Why?
One cause is loss aversion-an unwillingness to admit that the money is gone. It's never pleasant to realize that money was put in the garbage. It's not intentional, but subconsciously, to avoid feeling that we made the wrong choice, we hold onto that choice.
Another reason is because of optimism bias. We often have an unrealistic view that things will turn around and we'll make good on our investment. Yaakov may decide that it's worth it to put even more money into his car because then it will last him another five years and he won't need to do any repairs. Since the car is old and keeps breaking down, it's unlikely, but he keeps hoping that will be true.
Planning Fallacy
A planning fallacy is when we underestimate the time and cost it will take us to do a certain task.
The average man thinks he's smarter than the average man. Most of us think we can beat the system and not fall prey to scams. We're overly optimistic, imagining that we only need the shortest amount of time and will get the lowest price for what we're trying to accomplish.
The self-serving bias always plays a role. We tend to blame past failures on external factors and take credit for previous success.
Doing construction on one's home is a place where the planning fallacy often comes up. We Google the lowest prices, hear the lowest quotes, and decide that the project can be done in six weeks. We don't take into account that the price of labor may have gone up, there may be unexpected plumbing issues, and the tiles we like may cost more than we planned on spending.
Many people find themselves scrambling during a construction project, since they didn't put away enough money for it, assuming they would only pay the smallest amount.
ANCHORING BIAS
An anchoring bias is when we illogically rely on the first piece of information we received even when it isn't relevant anymore. For example, the Katzes bought their car three years ago, and now they want to sell it. They assume that they can get close to amount they paid for it, forgetting that the car is banged up and old cars always go for less. Since they know how much they paid for it, that's what they rely on.
This often happens when people buy stocks. If they purchased a stock at a historic high, they'll refuse to sell unless the stock hits that number again. They don't take the market and economy into account.
Employers also use this tactic in salary negotiations. They throw out a number, and then that's considered the going rate even if it's not accurate.
Overcoming Biases
It's difficult to overcome a bias, but awareness of the problem is half the battle. Approaching the situation from an outside per- spective or consulting with someone objective can help. Finally, don't rush into making financial decisions. Giving yourself time to think about your choice will help you avoid falling into a fallacy.
