Financial cognitive errors
Our approach to spending money can be influenced by cognitive distortions, that is, erroneous or inaccurate 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. Here are some examples of such distortions that can lead to unnecessary expenses.
1. Mental accounting.
Mental accounting is a concept created by behavioural 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, among others, the source of income (e.g. winning the lottery) and the purpose of expenses (e.g. money for monthly bills). For example, someone may spend extravagantly on entertainment while saving money on groceries.
As a result, this can lead to non-optimal financial decisions, such as spontaneously spending unexpected funds while managing earned money sparingly. This is due to the fact that a person using mental accounting does not perceive money from different sources as resources of equal value, which often results in irrational financial decisions.
2. Biased optimism.
Biased optimism is the belief that negative events are less likely to happen to us than to others. It is a mindset that can manifest itself in various areas of life, not just those involving finances. At its core is the conviction that bad things happen to others, but not to us. In the context of finances, this can lead to underestimating anticipated expenses or overestimating 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 error can affect not only individuals, but also the behaviour of entire social groups. Interestingly, economists consider excessive optimism to be one of the main causes of the 2008 global financial crisis. The unrealistic expectations of financial analysts, government officials and consumers regarding predictions of uninterrupted growth – despite clear signals to the contrary – likely contributed to this event.
3. Anchoring and adjustment effect.
The anchoring effect is a psychological phenomenon that involves excessive focus on initial information (known as an 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. last month’s spend), rather than a detailed assessment of one’s current needs or future plans. Anchoring can disrupt income forecasts, often leading to reckless spending.
4. Sunk cost effect.
The sunk cost effect is the cognitive error of continuing to invest in a project or financial decision solely because of the time, money or effort put into it, without considering the potential benefits of quitting. An example would be to continue studying despite losing interest in a particular field of study, only because of the “sunk” funds and time spent so far – instead of considering a change of field of study. Such a decision would save us additional resources and enable us to find a job in our dream profession.
Such cognitive errors have a major impact on our approach to financial decisions, often leading to unfavourable outcomes. Understanding these patterns can help you develop better strategies for effective financial management, reducing the risk of problems in crisis situations.
Psychology to guard 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.
1. Automated savings.
Many people, especially those having difficulty saving money, are characterised by a focus on the present. This leads to prioritising current spending over future savings. In this case, automating deposits to savings accounts can be extremely helpful. Setting up automatic transfers in a bank account, such as 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 sometimes be unreliable, especially if we tend to focus on the present.
The effectiveness of this method is confirmed by research by Richard Thaler and Shlomo Benartzi, published in 2004. They developed the SMarT (Save More Tomorrow) programme to help employees increase their retirement savings. A key principle of the programme was a prior commitment by participants to allocate a portion of future salary increases to retirement savings. The researchers worked with companies to offer this programme to their employees, with impressive results. Its participants nearly quadrupled their savings rate in 40 months – from 3.5% to 13.6% on average. This success was attributed to the application of behavioural psychology, which helped overcome the tendency to focus solely on the present.
2. Create separate “mental accounts” for different categories of expenses.
You can also use the mental accounting effect mentioned at the beginning of the article 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 holiday. This helps reduce overspending in one category by ring-fencing funds for other spheres of life. Dividing finances into smaller, targeted units can help you maintain discipline regarding spending.
3. Pre-commitment strategy to control spending.
This action involves setting spending limits or committing to financial goals in advance to avoid future temptations. Examples of this strategy include using savings accounts that have withdrawal limits or leaving home with a certain amount of cash. This consists in limiting access to resources that could be used impulsively, especially in situations involving emotions or strong temptations.
4. Divide long-term goals into smaller steps.
Long-term financial goals, such as saving for retirement, can seem overwhelming, which often leads to postponing decisions. To remedy this, you can break down the big goals into smaller and more manageable ones. Instead of focusing on setting aside the entire amount of savings needed for next year’s holiday, you can set smaller goals, such as putting aside a specific amount each month. This strategy is in line with research on goal-setting theory, which shows that achieving smaller milestones keeps motivation high and makes the larger goal seem easier to achieve.
Practicing mindful spending – that is, taking time to consider whether a particular purchase is in line with your 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 “Does it fit within my budget?”. This type of self-regulation supports us in decision-making and reduces impulsive spending, helping to keep attentiveness high and offsetting the influence of distractions.
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