Heuristics & Biases (Part 2)
AVAILABILITY HEURISTIC
A heuristic is a shortcut our brain makes. For example, if I look out the window and it's dark, I know it must be night. We need heuristics to function, but there is a downside: We rely on a system of our subconscious, and it can be easily fooled.
The availability heuristic leads to an overreliance on information we recall easily.
GEICO constantly advertises that they have the best rates. When Michael is looking for car insurance, GEICO is the first one that pops into his head. Since he's accustomed to seeing ads promoting GEICO, his brain automatically thinks of GEICO.
Bitcoin is currently at an all-time high. This can lead people to think that it's a great investment. I'm not commenting on that, but the snippets of news one hears aren't worth relying on. Do your research first.
After Hurricane Katrina, there was a large increase in buying flood insurance by people in areas with a low likelihood of ever flooding, since the flooding in New Orleans was all over the news and had catastrophic consequences for so many people.
Heuristics are necessary but can cause us to make illogical decisions. We may go with the brand that's frequently advertised, pick a stock we heard rave reviews about, or purchase an item we're not likely to need just because we heard about someone who did.
Awareness of heuristics alone won't help, since heuristics are essential to our functioning. We can't function if we always have to consciously discern if it's day or night when we look out the window. We need certain assumptions to shorten the thinking process.
Slowing down the decision process would help, though. Think about your reasoning and decide if it's logical. Look at the previous data. If there hasn't been a flood in your area in the last 50 years, it's probably not necessary to purchase flood insurance. Ask someone knowledgeable. Is this stock likely to continue its current upward trend? Do your research about other insurance companies before signing up with the first one you call.
It's not easy, but heuristics should be used only to benefit and not to harm.
Mental Accounting Fallacy
Mindy and Isaac conscientiously put $800 in savings each month while also paying off $750 on their car loans. They're not big spenders, but when they get their tax return, they go on a lavish vacation. They're not the type to invest recklessly, but when they received an inheritance, Mindy puts it into an exciting but risky venture, figuring that since it's inherited money, she can't lose anything.
These are all examples of mental accounting fallacy. Mindy and Isaac have mentally created different accounts in their minds. They were taught never to touch savings, so they shell out money for high-interest debt. They spend their regular earnings wisely, but easy or unexpected income is wasted. A thousand dollars has the same value regardless of where you spend it, but we view it differently depending on its background.
This mental accounting fallacy comes up most often when we make big purchases. Many people will pay $2,000 for a better trim when purchasing a $30K car. Compared to the final price, it doesn't seem like much. But that's irrelevant. The question to ask yourself is: Can you afford that extra $2,000?
When there's a massive sale on strollers offering $100 off a $300 stroller, dozens of people will travel across town to take advantage of the sale. But if someone is purchasing a $10K furniture set, they're unlikely to drive across town to save $100. The value of the money is the same, but the total price changes our perception of it.
Awareness is a big help in overcoming this fallacy. Look at the big picture of your finances so you can understand how every $100 makes a difference. Come up with a plan for possible bonuses or gifts, so you use them wisely. Finally, decide how much you're willing to spend on each category so you don't get sucked into the trap of viewing different categories of money differently.
EMPATHY GAP
An alcoholic listened with horror as his friend described some of the behavior he had seen from drunkards. "I wouldn't do that if I were drunk," he asserted. His friend gave him a sharp look. "If you were drunk, you'd be drunk! You can't predict what you would do when you aren't in that state." - Chafetz Chaim
When we're in one emotional state, it's difficult to imagine our feelings in another emotional state. If I go shopping when I'm starving, I might purchase all sorts of candy I would normally never touch. I'm projecting my current feelings onto the future without considering that a normal me would never do that.
Similarly, I can assume that in a moment of emergency I'll be calm, cool, and collected, but when that moment comes, I'll be in a different emotional state and might panic.
People make the worst financial decisions when they're stressed. When the stock market is up, I may resolve that I won't sell my stocks if it crashes, but when the fall actually occurs, I end up selling because I feel differently under stress.
While it's impossible to predict one's feelings when in a potential stressed state, coming up with a plan can help matters. You may want to write yourself a precommitment letter, out- lining what you would do in a crisis, to be read when you get there. And as always, slow down the decision-making. Hard financial decisions should never be made in a panic.
