How Common Cognitive Biases Affect Personal Finance

Lost MindA couple months ago, I wrote an interesting essay about how the “peak-end rule” affects personal finance decisions. For those unaware, the peak-end rule is a psychological phenomenon that indicates which parts of a past experience we recall and use to define that experience.

I found the whole thing fascinating and immediately began to look at other cognitive biases to see how they affect personal finance as well. After looking at dozens of biases, I selected three of the most interesting ones, and here they are:

Choice-supportive bias is an effect in which people are significantly more likely to remember positive attributes as having been part of the option they chose than that of the option they rejected.

For example, let’s say you’re shopping for cars and you’re down to a final choice between a Mercury Sable and a Lexus LS 300. Both have distinct advantages, but no matter which one you select, those are the advantages you will remember, not the advantages of the car you didn’t choose.

This bias affects future buying decisions, which is why we often get into a “rut” of buying the same product type over and over again. When we go to make a selection, it is much easier to recall the positive attributes of the product we purchased rather than the product we didn’t purchase.

How can I combat choice-supportive bias? Spend some time questioning all of your purchases in detail and give extra weight to the less-expensive product (remember to include all extra costs in this; don’t buy a junk car just because it has a lower sticker price). This way, you can train your bias to be biased in favor of the less expensive alternative, which will put money in your pocket.

Impact bias is the tendency of people to overestimate the length, intensity, or impact of future feeling states. In other words, people overestimate how strongly something will impact them in the future.

This one crops up a lot, actually. People often buy upper-end electronics and other items because of this bias. They look at the flat-panel HDTV at the electronics store, imagine themselves thoroughly enjoying it at home, and plunk down the cash, but when they get home, they discover little has truly changed about their television viewing experience. Advertising often preys on this bias, broadcasting images of people thoroughly enjoying their lives thanks to a particular product, and thus our impact bias makes us believe that the product will have a transformative effect, too.

How can I combat impact bias? If you have these great visions of how a product will improve your life, spend some time puncturing these delusions. Will you really watch more television if you get that HDTV? Will your lifestyle really change if you buy that dress? Usually, the answer is no, and that should be your answer to buying the product.

Hyperbolic discounting is the tendency of people to prefer smaller, quicker payoffs to larger, later payoffs when the small payoff is imminent. I like to use the analogy of someone saying “I’ll give you a five dollar bill now or a ten dollar bill in one year – which do you choose?” The vast majority of people would take the cash now.

This often shows up in consumer purchases, when people will make a beeline for “sale” items in a store because they can make a small savings there, when they might easily go online and save even more later. I’m often guilty of this myself with books, when I talk myself into buying a 30% off new release in hardback at the bookstore, when I could get it for 35-40% off online.

How can I combat hyperbolic discounting? Before you buy, do tons of comparison shopping, the more the better. This way, you eliminate the “hyperbolic” aspect of this effect and put all of the prices on the same timeline, which makes it easier for you to choose the best price.

If you are interested in this topic, I encourage you to seek out other cognitive biases (here’s a nice list of many such biases) and see if you can evaluate how they affect your purchasing choices – and how you can combat those biases to make yourself a more effective consumer.

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One thought on “How Common Cognitive Biases Affect Personal Finance

  1. the writer says:

    Is there another picture I should be seeing?

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