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Financial cognitive errors
Our approach to spending money can be influenced by cognitive distortions, that is incorrect or imprecise ways of thinking, perceiving, and formulating beliefs. They are a natural psychological process that — to a greater or lesser extent — can affect each of us. Below are some examples of such distortions that can lead to unnecessary expenses.
Mental accounting.
Mental accounting is a concept created by behavioral economist Richard Thaler. It is a mental process in which we classify and treat money in different ways based on subjective criteria. These can include, but are not limited to, the source of income (e.g. winning the lottery) and the purpose of spending (e.g. money for monthly bills). For example, someone may lavishly spend money on entertainment and at the same time save on grocery shopping.
As a result, this can lead to suboptimal financial decisions, such as spontaneously spending unexpected funds, while managing the money earned sparingly. This is due to the fact that a person using mental accounting does not perceive money from different sources as assets of equal value, which often results in irrational financial decisions.
Biased optimism.
Biased optimism is the belief that the probability of negative events is less for us than for other people. It is a way of thinking that can manifest itself in different areas of life, not just those related to finances. At its core is the belief that bad things happen to others, but not to us. In the context of finance, this can lead to an understatement of anticipated expenses or an overstatement of future income, resulting in insufficient savings. Biased optimism can also contribute to hasty credit decisions or setting overly ambitious financial goals.
The effects of this cognitive bias can affect not only individuals, but also affect the behavior of entire social groups. Interestingly, economists consider excessive optimism to be one of the main causes of the global financial crisis of 2008. The unrealistic expectations of financial analysts, government officials and consumers about forecasts of continued growth have likely contributed to this event — despite clear signals that the opposite will happen.
Anchoring and adjustment effect.
The anchoring effect is a psychological phenomenon that consists of an excessive focus on the initial information (the so-called anchor) when making decisions. In the context of budgeting and finance, this can lead to setting financial goals or spending limits based on a random number (e.g. spending from the last month), rather than a detailed assessment of your current needs or plans for the future. Anchoring can disrupt revenue forecasts, often leading to ill-considered spending.
The effect of drowned costs.
The drowned cost effect is a cognitive bias that consists of continuing to invest in a project or financial decision solely because of the time, money or effort invested in it, without taking into account the potential benefits of opting out. An example would be continuing your studies despite losing interest in a given field, only because of “drowned out” funds and time spent — instead of considering a change of direction. Such a decision would allow us to save additional funds and make it possible to find a job in your dream profession.
These types of cognitive biases have a big impact on our approach to financial decisions, often leading to adverse outcomes. Understanding these patterns can help us develop better strategies for effective financial management, reducing the risk of problems in crisis situations.
Psychology on the guard of saving
So how do 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.
Automation of savings.
Many people, especially those who have difficulty saving money, are characterized by an attitude towards the present. This leads to the prioritization of current expenses over future savings. In this case, it can be extremely helpful automation of deposits to savings accounts. Setting up automatic transfers to your bank account, for example, to a retirement account, eliminates the need for active decision-making 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 tend to focus on the present.
The effectiveness of this method is confirmed by studies by Richard Thaler and Shlomo Benartzi, published in 2004. They developed the SMart Save More Tomorrow program to help employees increase their retirement savings. A key principle of the program was the prior commitment of participants to allocate part of future salary increases to retirement savings. Researchers have worked with companies to offer this program to their employees, which has produced impressive results. Its participants nearly quadrupled their savings rate in 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 exclusively on the present.
Creating separate “mental accounts” for different categories of expenses.
The effect of mental accounting, 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 various financial purposes such as rent, entertainment or vacation. This helps to reduce excessive spending in one category by allocating funds allocated to other spheres of life. Dividing finances into smaller, goal-oriented individuals can help us maintain spending discipline.
Initial commitment strategy to control expenses.
This action consists of setting spending limits or committing to financial goals in advance, which avoids future temptations. An example of such a strategy is using savings accounts that have withdrawal restrictions or leaving home with a certain amount of cash. This action consists of limiting access to resources that could be used impulsively, especially in situations related to emotions or strong temptations.
Break down long-term goals into smaller steps.
Long-term financial goals, such as saving for retirement, can seem overwhelming, which often leads to postponing decisions over time. To remedy this, we can Break down big goals into smaller ones that are easier to accomplish. Instead of focusing on setting aside the entire amount of savings needed for next year's vacation, we can set smaller goals, such as setting aside a specific amount each month. This strategy is consistent with research on goal-setting theory, which shows that reaching smaller milestones keeps motivation high and makes a larger goal seem easier to achieve.
Practicing mindful spending — that is, taking the time to think about whether a given purchase is in line with our financial goals — can help counteract spending without a plan. Before making a purchase, it is worth asking yourself questions: “Is this purchase necessary?” , “Is it useful?” , and “Is it within our budget?”. This type of self-regulation supports us in decision making and reduces impulsive spending, helping to keep mindfulness at a high level and eliminating the influence of distractors.
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