Psychological Biases in Personal Finance

We all have our blind spots, but we can learn to recognize and protect ourselves against psychological truths that lead us to poor decision making. We describe some of the key psychological biases to be aware of in regards to personal finance below, and suggest how to overcome them. Get ready to become a decision making machine!

  1. Loss Aversion:
  • What is is?
    • Loss aversion is the thought that “the pain of losing is psychologically about twice as powerful as the pleasure of gaining. People are more willing to take risks (or behave dishonestly; e.g. Schindler & Pfattheicher, 2016) to avoid a loss than to make a gain. Loss aversion has been used to explain the endowment effect and sunk cost fallacy, and it may also play a role in the status quo bias.” – Behavioraleconomics.com
  • How does this impact personal finance?
    • Loss aversion creates a resistance to change. When we don’t acknowledge the effects of loss aversion we tend to spend too much time considering the potential losses associated with a new opportunity, which often causes us to remain in the status quo.
  • How can I protect myself from loss aversion bias?
    • Think of inaction in terms of what you stand to lose. I.e “what do I stand to lose if I don’t take action”. This will benefit those who tend to remain in the status quo.
    • Re-frame data you are considering both in terms of potential loss and potential gain.

2. Availability Bias:

  • What is it?
    • Recent events, and events that are vivid but uncommon, get disproportionately weighted in decision making processes.
    • More information available here.
  • How does this impact personal finance?
    • Have you ever heard of someone winning 9 figures in the lottery and thought to yourself, “man doesn’t that sound nice”? Or how about hearing of that college dropout who ended up starting a $1B company? Such positive outcomes are vivid and easily imagined events, which cause them to be more highly weighted in our thought processes. This can make such decisions appear smarter and more likely than they are in reality. In reality, purchasing a lottery ticket is quite a bad investment. See below for an equally funny and sad description of this…
  • How can I protect myself from Availability Bias?
    • Use documentation and statistics as opposed to imagination and visualization when making personal finance decisions.

3. Anchoring Bias

  • What is it?
    • Anchoring bias is the phenomena that people tend to rely on the first piece of information they receive too heavily.
    • See a good explanation and some illustrative examples here.
    • Anchoring bias is responsible for countless reproducible research findings. One study asked participants to spin a wheel to randomly arrive at a number between 1 and 100, and were then asked to estimate how many African nations were part of the United Nations. While clearly unrelated, participants who had spun higher numbers consistently estimated a higher number of African U.N member nations.
  • How does it impact personal finance?
    • When I last attempted to negotiate my rent, my apartment complex indicated to me that the rent offer they proposed was already $200 below “market value.” Instantly, I recognized that they were trying to give me a false anchor to make me more willing to accept their price. Want to take two guesses as to who determined this “market value”? Yep, you got it! The apartment complex itself.
    • Negotiating with a car dealer? Try your best to follow the steps outlined below to avoid falling victim to anchoring bias.
  • How can I protect myself against anchoring bias?
    • Actively consider new information that starts with an entirely new anchor.
    • Physically write down what you think it a proper and fair offer before ever hearing information presented from the other side of a negotiation.

Starting to think about how some of these blind spots can show up in daily life is an easy way to improve many aspects of your financial fitness. Now that we’ve got you thinking about them, let us know how you see these and other psychological biases come to life!