Here’s the science behind our stupid money mistakes

The human brain is a marvel of evolution. We are able to make quick and relatively accurate decisions based on very little information because we learn from previous experiences as well as the experiences of others. Unfortunately, that marvelous ability is also a serious pitfall, since we’re likely to jump to conclusions. This sometimes leads to stupid money mistakes.

Specifically, we humans are vulnerable to cognitive biases that lead us astray. These biases are systematic patterns in how we think that can lead to less-than-rational conclusions and behavior. For example, I can vividly recall waffling on whether or not I wanted to buy a shirt because it seemed a bit expensive–but when I learned I could get a second shirt for half-off, I quickly purchased both. Which meant I spent even more money to get two shirts I wasn’t sure I wanted.

These are not the actions of a rational agent.

The good news is that cognitive biases do follow patterns and can be predicted. Here are some of the most common biases that could be affecting your financial decisions.

Anchoring: Cheap isn’t what you think it is

Deciding how much you’re willing to pay for something may feel like a straightforward and rational process, but you have a lot less control over it than you think you do. That’s because we all carry anchor prices in our heads of what is an appropriate amount to pay for things, which leads to frequent money mistakes.

For example, let’s say you go out for a nice dinner with your best beloved. You want to order a nice bottle of wine and see there is a very pricey bottle of red for $98. Right next to it is a much more modest bottle that costs $36. That seems like a great price compared to the $98 bottle, so you order it. But you and your sweetheart would have been perfectly happy with the $20 bottle of wine.

In fact, the restaurant keeps the $98 bottle of wine on the menu because it sets the price anchor high enough that a $36 bottle of wine feels like a bargain.

Combating price anchors

From dining out to real estate to the cost of financial advice, marketers set anchor prices that convince you to spend more than you otherwise would. It was the effect of anchoring that persuaded me to buy two shirts for more money than I was willing to pay for one.

Fighting this cognitive bias isn’t easy because money has no inherent value. There is no way to determine a rational or natural price for anything, because goods and services are worth what people are willing to pay for them. However, you can create self-imposed anchors to keep marketing anchors from muddying your thinking.

For example, you might think about prices in terms of how many hours you have to work to earn the money. If you make $80,000, that’s equivalent to about $40 per hour. While you’re out to dinner, you can decide if you’re willing to spend two and a half hours at work for the $98 bottle of wine, 1 hour for the $36 bottle, or a half hour for the $20 bottle. Thinking about your spending in terms of hours can help you avoid money mistakes by allowing you to make a clearer decision about how much you’re willing to spend.

Sunk-cost fallacy: When you keep digging

Sunk costs are the resources—like money, time, or energy—that have already been spent on something and cannot be recouped.

For example, a college student who is halfway through the course load to become a teacher has decided they want to be a marine biologist instead. The student can’t get back the money and time they have already spent on their teaching degree, but those sunk costs should have no bearing on the student’s decisions going forward. The money and time can be recouped, so they need to make decisions as if the sunk costs don’t matter.

But a cognitive bias known as the sunk-cost fallacy often leads to money mistakes by making us think that we can’t change course because of sunk costs. The fear of “wasting” the money and time might prompt the student to continue on an educational path they don’t want. The problem with this fallacy is that the money and time are “wasted” no matter what the student decides to do, and continuing to pursue an unwanted goal will only waste more time and money.

Combating the sunk cost fallacy

A good way to fight the sunk cost fallacy is to imagine you have just woken up with amnesia. Without any knowledge of the past sunk costs, what’s the best way to move forward? The aspiring marine biologist might realize that they are much more interested in starting their scientific education from scratch than continuing with the teaching degree that’s already in progress.

Asking yourself how you would react to the situation without prior knowledge of it can help you determine the best and least expensive course of action.

Availability heuristic: When statistics don’t apply to you

Our brains believe that something we can easily recall is more likely to happen than something we don’t remember. This is why flying is such a common phobia, even though there are more than 115 car fatalities daily compared to approximately 1 death per year in commercial air travel. But since any airline crashes make headline news for days or weeks at a time, while we only hear of car crashes we are personally connected to, our brains find it more plausible that we’ll die when we fly.

In financial decisions, the availability heuristic makes us believe we are all temporarily embarrassed millionaires. We’re all sure the winning lotto ticket, the big win in Vegas, or getting on the ground floor of the next version of crypto currency is just around the corner. It’s easy to remember the individuals who have done each of these things, while the folks who quietly become millionaires through frugal living and savvy long-term investments generally don’t get glowing coverage in the news.

Combating availability heuristic

There’s a two-pronged trick to avoiding money mistakes caused by availability heuristic. The first is to ask yourself how likely something is. Yes, you have the same chance of winning the billion-dollar Powerball as anyone else who buys a ticket—but just how likely is it? If statistics aren’t on your side, then don’t count on it.

The second part is recognizing when you’re making emotional decisions. It can be easy to reject the low statistical probability of getting in on the ground floor with the can’t-fail Bolivian tin mine you’re investing in when you’re busy imagining riches you’ll be swimming in and how satisfying it will be to rub it in your ex’s face. If you are focused on how a particular outcome will make you feel, despite its low probability, you’re likely succumbing to availability heuristic rather than rational thinking.

Cognitive biases: Your brain’s tripping hazards

We are not logic-minded actors who carefully consider the cost-benefit analysis before each decision. Instead, each one of us is several dozen mental shortcuts in a trench coat pretending to be a rational adult.

Learn to recognize when you’re using someone else’s anchor prices, falling for the fallacy that sunk costs can somehow be recouped, or assuming that something is more likely because you can easily recall examples of it. Knowing these cognitive biases can help keep you from tripping into your next financial mistake.