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Cognitive Biases That Are Costing You Money

On pay day you see a large amount on the debit card and think that now you can buy everything. Because of this, a lot of money is spent on minor things, and by the end of the month you have to save. Have you encountered something like this? Most likely, yes, because these are common cognitive distortions.
be-in-the-loop - Cognitive Biases That Are Costing You Money

On pay day you see a large amount on the debit card and think that now you can buy everything. Because of this, a lot of money is spent on minor things, and by the end of the month you have to save. You agree to get paid less for work, but right now, than wait a while for more earnings. You feel greedy to pay for a large purchase, but you can easily spend on many small ones. 

Have you encountered something like this? Most likely, yes, because these are common cognitive distortions.

We do not take into account the real value of money

We forget that the ability to buy something depends not only on the number in our account, but also on price fluctuations. If your salary is increased, it does not mean that you have become richer. After all, due to inflation, commodity prices have also risen. This is exactly the money illusion. It seems to us that the goods cost the same, but their value is constantly changing. You can buy different goods for the same money at different times.

This phenomenon was firstly discussed in 1928. Economist Irving Fisher described it as “not understanding that the value of the dollar or any other currency is rising or falling”. It even affects our satisfaction with our position. In 1997, behavioral psychologists confirmed this during experiments.

be-in-the-loop - Cognitive Biases That Are Costing You Money

They described the situation to the participants: there are two men, they have the same education, position and starting salary. According to the terms of the task, there are different levels of inflation in cities where they live, moreover, their salaries were also increased differently.

• The first man gets: $ 5,000 salary, 0% inflation, 2% increase.

• The second man gets: $ 5,000 salary, 4% inflation, 5% increase.

Three groups of participants were asked to answer one of the questions: whose position is more economically advantageous, which of these people is happier and whose position is more attractive. From the point of view of real incomes, the position of the First is more favorable. After deducting inflation, his salary is higher than that of the Second. Most people responded had such a reply when asked about the economic benefits.

But the question of happiness was answered differently — they said that the Second was happier. This is how the money illusion manifests itself. People think that a higher increase means more money, and therefore more happiness. It makes us think that the position of the Second is more attractive.

How to Deal With It

When making financial decisions, try to think rationally. Don’t give in to emotions. Remind yourself of inflation and the real value of money.

hyperbolic depreciation

be-in-the-loop - Cognitive Biases That Are Costing You Money

Let’s say, you’re offered $ 5,000 today or $ 10,000 in a year. Most would choose $ 5,000 at once. When we have a choice, we will prefer to get something immediately, even if its value is less. The future reward is not so important for us, we devalue it.

But if you are set the question a little differently: $ 5,000 in nine years or $ 10,000 in 10. In this case people are more inclined to get the second option. When it takes longer to obtain a reward, we think more rationally and choose a larger amount. But to make the right choice in the short term is more difficult for us. This explains credit card debts. Financial stability in the future does not seem as valuable as the opportunity to buy something nice right now.

This cognitive distortion affects not only finance, but in general everything related to self-control. Dependencies, eating habits, those areas in which you need to give up immediate pleasure for the sake of future well-being.

Some scientists attribute this to evolution. When your distant ancestor saw a small skinny antelope, he tried to catch and eat it, and not to wait for larger prey. Because it was possible not to live up to this point. As a result, a mechanism has developed in the brain that encourages immediate reward.

How to Deal With It

Protect yourself from temptations in advance. In order not to spend on momentary pleasures, set a limit on card expenses. Make your savings automatic. Report to someone about your spending.

Before making a decision, imagine yourself in the future: if the “future you” will approve such a choice. So you evaluate the facts more objectively.

denomination effect

be-in-the-loop - Cognitive Biases That Are Costing You Money

t often happens like this: we are scared to spend money on a large purchase, but not on many small ones. The denomination effect is to blame for this, or in another way the effect of the value of banknotes. Large bills seem to us more valuable, it is a pity to exchange them. We mentally consider them “real” money. And bills of lesser denomination and coins are not so valuable for us, it is easy to part with them.

Scientists described this effect in 2009 by conducting a series of experiments. In one, they asked people to take a short survey, and in return they gave them five dollars. Someone with one banknote, and someone with five one-dollar banknotes. After that, participants could go to the store and spend what they received. Then the researchers asked to see their checks. It turned out that people who received a five-dollar banknote basically refrained from spending.

This effect concerns all people, but it is especially shown up in countries where people often pay in cash.

The denomination effect has another manifestation. The purchase seems to us more profitable if the price is indicated not by one amount, but allocated by days or months. It’s easier for us to pay $ 10 per day for the service than $ 3,650 per year.

How to Deal With It

If you want to save money, do not carry a lot of small money with you. It is psychologically more difficult to part with a large bill, even if we know that we will get change from it. Use this as a defense against excess spending.

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