Even those that are trying their hardest may be prevented from optimising their personal budget due to their own mental lapses. These mistakes, referred to as cognitive biases may cost small amounts here and there, but can also amount to huge losses if you're not careful. In this article we examine some common cognitive biases and explain how they could be ruining your budget.
Diminishing Sensitivity & Home Loan Rates
The phenomenon of "diminishing sensitivity" suggests that we are less responsive to changes the further they are from a reference point. Professor Jonah Berger, from the Wharton School at the University of Pennsylvania, conducted a study in which 87% of participants said they would drive an extra 20 minutes to save $10 on a clock radio normally priced at $35, but they would not make the same trip to save the same $10 on a TV normally priced at $650, even though the savings and time of travel was the same in both scenarios. These findings suggest that certain personal finance optimisations may feel insignificant even if they offer valuable savings.
While missed savings on a television might not be a huge deal, this type of bias can cost you even more in certain situations. For instance, imagine that you currently have a home loan with an annual interest rate of 10% p.a., but could refinance at 9%. Many homeowners would not see the advantage of switching to a slightly lower rate. This could be a big mistake, given that even a slightly lower interest rate could actually represent a significant amount of savings over the course of your loan. For example, the total cost of a 25-year, Rs. 300,000 home loan with a 9% interest rate is Rs. 62,554 less expensive than the same loan with a 10% rate over the entire course of the loan. This highlights the importance of conducting thorough research before applying for a home loan and periodically to see if you should refinance your housing loan in order to ensure that you secure a great rate.
Loss Aversion & Retirement Planning
Research also indicates that humans are irrational when it comes to understanding risk and potential gains and losses. Nobel Prize-winning behavioural economist Daniel Kahneman conducted research in which he told his participants that in a fair coin flip they would lose $10 if the coin landed on tails. When he asked them how much they would require in order to take the deal he found that the participants consistently required twice as much if the coin would land on heads. Kahneman concluded that individuals are more concerned with losses than they are with potential gains.
This way of thinking can hinder those that are trying to invest and save for retirement. While it may appear prudent to keep your retirement savings in a savings account, you are likely to miss out on higher returns from other investments over the long run. As an example, the stock market has traditionally earned higher annual average returns (approximately 7-10%) compared to lower interest earning accounts. Even the risk averse can find better ways to invest their money with proper research. We recommend developing a strong understanding of various markets and investing strategies before investing your own money.
Survivorship Bias & Attending University
Cognitive biases can increase our housing expenses and limit the accumulation of our retirement funds. They can also give us unrealistic career expectations. For instance, given the success of college dropouts-turned industry moguls such as Steve Jobs, Bill Gates and Mark Zuckerberg, it is easy to think that anyone could be just as successful without completing a college degree. This is an example of survivorship bias. While those three entrepreneurs did achieve incredible success, they should be viewed as exceptions, as nearly all other dropouts are less successful. While it is possible to have a great career without a university degree, this investment still offers a relatively high return.
Anchoring Bias & Negotiating with Salespeople
Another common bias is called "anchoring". The anchoring bias was identified as a tendency for individuals to rely heavily on the first piece of information that they receive. Amos Tversky and Daniel Kahneman found that participants' estimates for the number of African countries in the United Nations was influenced by the number the participant had spun on a wheel earlier in the experiment. This suggests that once we are given a number, our perspective is "anchored" to this number. This can be costly when shopping without conducting any prior research. For example, the price that a salesperson presents may mentally tether us to a certain price range at the start of negotiations. For this reason, it is crucial to set your own price expectations by conducting your own review prior to negotiating on the price of goods or services.
Identify Your Biases to Save Money
Findings from behavioural psychology give us an increasingly accurate understanding of our decision making processes and logical limitations. You are likely not susceptible to all of the biases on this list, but it should give you an understanding of the types of pitfalls that exist. Hopefully you will be able to use this knowledge to make strong financial decisions.