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Financial cognitive biases
Our approach to spending money can be influenced by cognitive distortions, which are flawed or inaccurate ways of thinking, perceiving, and forming beliefs. They are a natural psychological process that—to a greater or lesser extent—can affect any of us. Below are a few examples of such distortions that can lead to unnecessary spending.
Mental accounting.
Mental accounting is a concept developed by behavioral economist Richard Thaler. It is a mental process in which we classify and treat money differently based on subjective criteria. These can include, among other things, the source of income (e.g., a lottery win) and the purpose of the expenditure (e.g., money for monthly bills). For example, someone might spend money lavishly on entertainment while simultaneously being frugal with grocery shopping.
As a result, this can lead to suboptimal financial decisions, such as impulsively spending unexpected funds while managing earned money frugally. This is because a person using mental accounting does not perceive money from different sources as having the same value, which often results in irrational financial decisions.
Optimism bias.
Optimism bias is the belief that the probability of negative events occurring is lower for us than for others. This is a way of thinking that can manifest in various areas of life, not just finance. At its core is the conviction that bad things happen to other people, but not to us. In a financial context, this can lead to underestimating projected expenses or overestimating future income, resulting in insufficient savings. Optimism bias can also contribute to hasty credit decisions or setting overly ambitious financial goals.
The consequences of this cognitive bias can affect not only individuals but also the behavior of entire social groups. Interestingly, economists consider excessive optimism to be one of the main causes of the 2008 global financial crisis. This event was likely fueled by the unrealistic expectations of financial analysts, government officials, and consumers regarding the prediction of uninterrupted growth—despite clear signals that the opposite would occur.
Anchoring and adjustment effect.
The anchoring effect is a psychological phenomenon that involves focusing too heavily on the initial piece of information (the "anchor") when making decisions. In the context of budgeting and finance, this can lead to setting financial goals or spending limits based on an arbitrary number (e.g., last month's expenses) rather than a detailed assessment of one's current needs or future plans. Anchoring can distort revenue forecasts, often leading to ill-considered spending.
Sunk cost fallacy.
The sunk cost fallacy is a cognitive bias that involves continuing to invest in a project or financial decision solely because of the time, money, or effort already put into it, without considering the potential benefits of quitting. An example would be continuing your studies despite losing interest in your major, simply because of the "sunk" funds and time already spent, rather than considering a change of major. Such a decision would save additional resources and allow you to find a job in your dream profession.
These types of cognitive biases have a major impact on our approach to financial decisions, often leading to unfavorable outcomes. Understanding these patterns can help us develop better strategies for effective financial management, reducing the risk of problems in crisis situations.
Psychology as a guardian of savings
So, how can you effectively improve your financial habits using psychology? In addition to avoiding the cognitive distortions mentioned earlier, it is worth implementing proven strategies, such as those described below.
Automating savings.
Many people, especially those who struggle to save money, have a present-oriented mindset. This leads to prioritizing current expenses over future savings. In this case, automating transfers to savings accountscan be extremely helpful. Setting up automatic transfers in your bank account, for example to a retirement fund, eliminates the need to make active decisions and reduces the temptation to spend money on short-term whims. Such automation makes financial planning easier and less dependent on willpower, which can be unreliable, especially if we have a tendency to focus on the present.
The effectiveness of this method was confirmed by research conducted by Richard Thaler and Shlomo Benartzi, published in 2004. They developed the SMarT program – Save More Tomorrow – to help employees increase their retirement savings. The key principle of the program was for participants to commit in advance to allocating a portion of future salary raises to retirement savings. The researchers worked with companies to offer this program to their employees, which yielded impressive results. Participants nearly quadrupled their savings rate over 40 months, from an average of 3.5% to 13.6%. This success was attributed to the application of behavioral psychology, which helped overcome the tendency to focus solely on the present.
Creating separate "mental accounts" for different spending categories.
The mental accounting effect, mentioned at the beginning of the article, can also be used in a positive way by creating separate "mental" or even physical accounts (e.g., separate bank accounts) for different financial goals, such as rent, entertainment, or vacations. This helps curb overspending in one category by isolating funds intended for other areas of life. Dividing finances into smaller, goal-oriented units can help us maintain spending discipline.
Pre-commitment strategy for controlling expenses.
This involves setting spending limits or committing to financial goals in advance, which allows you to avoid future temptations. An example of such a strategy is using savings accounts that have withdrawal restrictions or leaving the house with a specific amount of cash. This action involves limiting access to funds that could be used impulsively, especially in situations involving emotions or strong temptations.
Breaking long-term goals into smaller steps.
Long-term financial goals, such as saving for retirement, can feel overwhelming, which often leads to procrastination. To address this, we can break large goals down into smaller, more manageable steps. Instead of focusing on saving the entire amount needed for next year's vacation, we can set smaller targets, such as putting aside a specific amount each month. This strategy aligns with research on goal-setting theory, which shows that achieving smaller milestones keeps motivation high and makes the larger goal feel more attainable.
Practicing mindful spending—taking the time to consider whether a purchase aligns with our financial goals—can help counteract unplanned spending. Before making a purchase, it is worth asking yourself: "Is this purchase necessary?", "Is it useful?", and "Does it fit within our budget?". This type of self-regulation supports our decision-making and reduces impulsive spending, helping to maintain a high level of awareness and minimizing the impact of distractions.
References:
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