Our brains are not naturally wired to make the kinds of decisions that lead to long-term financial stability and wealth. That's because most of us fall victim to systematic errors in logical thinking known as cognitive biases. Our brains have trouble recognizing when we are about to make a logical error, and it's only in hindsight that we realize we have screwed up.
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Fortunately, once you are aware of your cognitive biases, it is easier to combat their influence. Here are five cognitive biases that are working to keep you poor, and ways you can bypass their effect on your behavior.
Determining an appropriate price for a purchase could be exhausting, if you were to do research on how much every single vendor is charging for the same item. To save ourselves from such effort, our brains take a shortcut known as anchoring. The anchor is a price point that gives you an idea of how much something should cost.
For instance, let's say you are interested in hiring a personal trainer. The first trainer you call charges $60 for 30-minute sessions. The second trainer you call charges $70 for 30-minute sessions. Clearly the first trainer is the better financial choice, right?
Actually, based on the information you have, you have to ask yourself if that is really the case. With further research, you might find that both of the trainers you called are overcharging since the majority of trainers in your area charge $30 per 30-minute session. Since you do not have an anchor point in your mind when you start researching personal trainers, you assume that $60 is a reasonable price -- making $70 too high a price to pay -- even if neither of those amounts have anything to do with what most customers are paying.
Anchor points are very difficult to ignore, because it can be tough for you to remember that the anchor price you are thinking of does not necessarily reflect how much something should cost.
How to Combat Anchoring
One way to circumvent the problem of anchoring is to create your own anchor to redefine the amount of money you would otherwise spend. Take the time to start looking at financial transactions in terms of the hours you spend to get them, rather than the dollars.
This suggestion comes from the book Your Money or Your Life. In this book, Vicki Robin and Joe Dominguez point out that time is literally money, since you trade your time away in order to earn money. And while money is fungible (that is, replaceable), your time is finite, precious, and gone once it's spent.
We may feel like we deserve the latest gadget -- but remembering just how much of our lives we would have to give up for it can help us remember to only spend on the things that truly reflect our goals.
2. The Availability Heuristic
The availability heuristic is a kind of memory shortcut that helps you determine how likely something is. Your brain assumes that things you can easily recall are more probable than things that are hazier.
For instance, you are probably much more nervous when you board an airplane than you are when you get in the car, despite the fact that there are 100-plus car fatalities daily in America, while air travel is one of the safest modes of transportation. But since every plane crash makes both national and international news, and there is generally nothing more than local coverage of car crashes, it seems to our brains that plane crashes are more likely.
When it comes to our finances, the availability heuristic leads us to believe that winning the lottery, winning big in Vegas, or making a killing on the stock market are all more likely than they are. Since we can remember the names and stories of individuals who have gotten rich in these ways -- and we don't remember the stories of people quietly amassing a small fortune through savings and frugal living -- we think our own chances are better in risky financial situations.
How to Combat the Availability Heuristic
To combat this cognitive bias, you need to recognize when there is an emotional component to your decision. Does your choice reflect any kind of statistical probability, or does it simply feel as if the outcome you are hoping for (or alternatively, trying to avoid) is the likeliest one?
It is also helpful to spend time educating yourself on financial statistics to help you understand when your reaction is irrational.
3. Hedonic Adaptation
Hedonic adaptation describes the phenomenon wherein we get used to the things we have. Think of the pleasure and pride you felt upon first purchasing your car. I'm guessing your delight in your new vehicle faded before the new car smell had completely dissipated. This happens because our brains are wired to get used to things fairly quickly.
This means that no purchase will permanently satisfy us, and if we're not careful, we're likely to keep reaching for another thing to buy that will offer momentary pleasure or satisfaction. But it is only a matter of time before the new purchase also becomes old news, spurring another purchase to keep the pleasure going.
This cognitive bias also helps explain why it is so easy for you to become just as financially stressed after a major pay raise or other financial increase as you were at the lower level. When the things that were rare treats when you were earning less become a standard part of your life, you enjoy them less, but you are also less willing to give them up.
How to Combat Hedonic Adaptation
Regularly expressing gratitude for the things in your life can help you feel both more optimistic and happier, according to Robert A. Emmons, professor of psychology at the University of California, Davis. That increased happiness can help end the constant search for pleasure through purchasing.
According to Emmons, a gratitude journal, wherein you regularly record things for which you are grateful, can help you improve your mood, as well as your physical and social well-being, and help you recognize the abundance that is already in your life.
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4. Hyperbolic Discounting
Let's say I offered you $100 right now, or $110 in 10 days. Which would you prefer? If you're like most people, you'll take the Benjamin today, even though a relatively short wait would earn you 10% more. It is human nature to prefer something to happen immediately, rather than wait patiently for a larger reward later.
This preference for instant gratification is a cognitive bias known as hyperbolic discounting. Our brains "discount" something that will happen in the future as less important than something that is happening in the here-and-now. It's the reason why you can decide on January 1 that you want to pay off your credit card debt in the new year, and find yourself charging $200 worth of new video games less than a month later. The debt payoff is so far away, and the video games are tempting you right now.
Hyperbolic discounting causes us to push today's consequences into the future. We decide that avoiding the consequence today means that the consequence is not our problem, even though it will be when the time comes. This is actually the very basis of credit card business practices.
How to Combat Hyperbolic Discounting
The effect of hyperbolic discounting diminishes as you place decisions in the future. For instance, if I were to ask you if you wanted $100 on February 4, 2018 or $110 on Valentine's Day of that year, you'd probably be happy to wait. Since you are waiting until the following year anyway, it's easier to decide to wait the additional 10 days for the extra 10%.
To combat the effects of hyperbolic discounting, imagine your current dilemma as if it will happen in the future. Doing this can help you to see the issue more rationally and help you come to the decision that your future self will be glad you made.
5. The Restraint Bias
Most people tend to overestimate their own impulse control. This is why your decision to stop getting takeout instead of cooking at home is derailed when you drive past your favorite burger joint. You have overestimated your ability to be virtuous in the face of temptation. The restraint bias is often the culprit when you can't maintain your New Year's resolutions.
When you were making the resolution, you were certain that you could restrain yourself around temptations. You forgot that you will be just as flawed and human in the future as you have been in the past.
How to Combat the Restraint Bias
This may sound overly simplistic, but the easiest way to combat restraint bias is to avoid tempting situations. Instead of believing that you should be able to drive past In-N-Out without stopping for a Double Double Animal Style burger, you can simply take a different route home that won't lead you past the temptation. This takes the issue of restraint out of your hands when you are most tempted.
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Don't Let Your Brain Destroy Your Finances
Cognitive biases are a fact of life, but they don't have to destroy your financial security. Understanding the ways that your brain leads you astray is the first step in avoiding your most money-wasting errors in logic.
More From Wise Bread
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- 6 Ways Sloth Is Keeping You Poor
- 6 Ways Gluttony Is Keeping You Poor
- How to Shop With Purpose -- And Save More Money
Copyright 2017 The Kiplinger Washington Editors