Personal finance is a difficult topic for most people. It combines several different tasks that the human brain just isn't wired to handle well, like forecasting a long ways into the future, making numerical predictions and calculations based on those forecasts, and assessing risk. Moreover, buying a house, saving for retirement, or other big financial decisions tend to be emotionally charged, so making an informed decision is even more difficult.
Humans have a variety of inherent biases in how they see and interpret the world. In finance, the way these biases interact with how people making decisions about money is called behavioral finance. Understanding behavioral finance is important, because circumventing these biases in human reasoning is a good way to avoid falling into financial traps. Sometimes, salesmen make use of these blind spots in order to sell at a higher price. Other times, there is nobody responsible- a bias can simply change the way people feel about a transaction. Learning about these biases makes it possible to avoid them, saving time and money.
The Sunk Cost Fallacy
The sunk cost fallacy is a common issue in behavioral finance. It can trap people into spending money when it isn't a good idea. The best way to summarize the sunk cost fallacy is with a common proverb: "don't throw good money after bad." The sunk cost fallacy causes people to feel invested in a project or endeavor, making them want to keep putting money into it even after it is clear that the project is not going to pan out.
Consider the case of a hypothetical man named Bob. Bob has seen a lot of television about flipping houses for profit and wants to try it for himself. In his eagerness, Bob buys a house without examining it closely. As he begins to renovate the house, Bob learns about its problems: it has a leaky roof, a crack in the foundation, and it might be in violation of his town's laws on lead in pipes. Even after learning this, Bob continues to spend money on fixing up the house, reasoning that he has come this far already, so it would be a waste to give up now.
He eventually sells the house at a loss, having spent thousands on the renovations and selling it for less than he bought it. The sunk cost fallacy impelled Bob to keep putting time and money into the house after he realized that it was unlikely to do well on the market. If he had been honest with himself about the house's prospects, he would have stopped putting money into the house and cut his losses. But people find it hard to give up on projects, because it requires admitting that their judgement was wrong when they first began them.
The sunk cost fallacy is pervasive and dangerous because it keeps people in losing propositions. Understand how it works and be honest about whether a venture will work out, and if it won't, be prepared to walk away.
Related Article: How to Deal with Tricky Money Situations
Anchoring
Anchoring is a particularly problematic bias because salesmen and other price setters can and will use it to lure buyers into paying more money than they otherwise would. The trick is simple: the human mind tends to latch onto the first number it sees.
For example, a new computer that costs $600 but is marked down to $500 sounds much better than a flat $500 computer, even though there is no difference in price. The large difference between the first number, $600, and the second, $500, makes the buyer feel like they are getting a deal, even though only one number matters- the final price. Sellers exploit this by continually running large "sales" where they sell inventory at a big discount from the "regular" price. The truth is that nobody ever pays that regular price, and the sale is just an illusion to make the buyer feel like they found a bargain.
Try to ignore the "regular price" of an item on sale. It's completely irrelevant to the real price. The size of the discount doesn't matter, because the seller can create any kind of discount they want. The final price is what really matters for the household budget.
Related Article: When Should You Make That Big Purchase?
Opt-Out
The opt-out problem isn't so much a bias as it is a way to exploit the natural human inclination for laziness. This is something many people experience in the form of free trials and similar offers. They promise a 30-day free usage of software for anyone who puts in their credit card information. If the person does not remember to go in and end the trial, opting out of the free version, they will be charged the full version's price.
The bias depends on the fact that people are not inclined to change things once they are in place, so marketers and sellers set up products that will start costing money if the buyer does not act. The buyer needs to manually opt out in order to escape the fees. Many people will forget about the opting out process or put it off because it requires time and effort. Later, they find a surprise fee on their credit card bill.
Keep careful track of all free trials and similar offers- they may have a clause that kicks in to start charging money if the contract is not ended by a certain date.
Conclusion
It is important to distinguish between information about a product that is helpful and information that is meant to mislead the buyer. That helps filter out the irrelevant noise.
Self-awareness is the biggest weapon against the mental biases that can trick people. By being careful about knowing exactly what is at stake, it's possible to avoid these biases. Rushing into a financial decision without thinking it through risks a mistake, and these biases are a plentiful source of such mistakes. Learn them, understand them, and recognize them.
