We all like to believe that we are rational people and we make rational decisions based on our own preferences. But this isn’t always the case. Interestingly, our brain likes to play tricks on us, causing our thought process to be influenced by mental shortcuts known as cognitive biases. These cognitive biases have the potential to alter our perception of reality and prevent us from making logical judgments and acting rationally.
Here’s a closer look at some of the cognitive biases that influence us in making financial decisions.
Loss aversion
The findings of research indicate that people despise losses far more than they despise gains. Loss aversion is quite common when it comes to financial decisions.
In this context, consumers are compelled to make purchases by the fear of losing something or missing out. In neuromarketing, activating the fear of missing out is one technique to prompt buying decisions. Discounts for a short length of time is a classical example for use of the loss aversion bias. Such as: “40% off for purchases within 24 hours!” “Early bird offer — Save 30%, expires in 2 days.” We are more prone to make hasty purchasing decisions when there are short-term discounts because we are afraid of missing out on a good offer.
Another example can be taken from the investment sectors to show why people tend to avoid losses more than winning gains. Studies show that Loss aversion can cause clients to cling on to investments that have lost value in order to avoid a portfolio loss, even though selling is the best option.
According to research, loss aversion is lower when people make decisions for their future selves than when they make decisions for their current selves. Therefore, asking yourself questions for your future self such as, “How is this purchase going to help me in the long run?’’ is an easy method to reduce the impact of loss aversion. This helps people to put their losses into perspective, allowing them to better justify whether or not making a decision now is worthwhile.
Anchoring
This overly reliance on pre-existing information is known as anchoring bias. In most cases, we base our decisions on the first piece of information we hear. In a negotiation, for instance, the first person to offer a price is usually the one who establishes the range of options in the minds of those whom to follow.
For example, if you first see a pair of pants for 1500 SEK and then see another for 500 SEK, you will believe the second pair of pants is inexpensive and a good deal, however, if you first see it for 500 SEK, you may not think it is cheap at the time.
However, individuals can either benefit from or be disadvantaged by ‘anchoring’. On one side, it may lead us to purchase expensive goods since we “anchored” our judgment around the first price we were presented with. On the flip side, it enables us to make quick and reasonably accurate estimates whenever they are required.
The simplest method to avoid the anchoring bias is to keep track of one’s behavior and identify the anchors that tend to wear you down. You will also be able to make rational decisions by doing easy research and price comparisons of the same item in different stores, which in turn improves your purchase decisions.
Status quo
Status quo bias refers to our preference to continue on the same path rather than change. In terms of decision making, this bias encourages us to maintain the course by doing nothing or sticking to a previous decision, even when better and more effective options exist. This is due to our mind’s preference for what it already knows.
Another factor that impacts status quo bias is what the majority of people are doing. People in this situation make decisions by just going with the flow, as it needs the least amount of effort. For instance, if the majority of people around us buy the same insurance policy, we are more likely to do so as well.
On one hand, Status quo bias prevents people from taking unnecessary risks, and it gives some sense of security to them, but on the other hand it makes you miss out on acquiring something better. For example, some choose to keep their money in savings accounts rather than making investments such as in the stock market because they believe their money is safer in the bank than in the stock market. Even if the stock market is more beneficial in reality, they choose to avoid taking any risks.
Changing this inertia requires strong motivation or incentives. As a result, the best thing to do is get financial guidance from professionals and educate yourself about different possibilities and their associated benefits.
Framing Effect
The framing effect is a cognitive bias that influences our decision-making when the same thing is expressed in different ways.
In this case, the outcome will be the same regardless of whatever option is chosen. When the options are phrased differently, however, we are more likely to choose the one that is more favorable.
For example, if you are looking to buy good toothpaste that has good recommendations and If the advertisement reads, “Ten out of nine dental experts recommend this,” you’re likely to assume it’s an excellent product. But If you read ‘10% of experts don’t recommend this product,’ you might not think it’s a very good product.
People tend to avoid risks when it is presented with a negative frame and seek for opportunity when it is presented with a positive frame. However we need to be aware of how product framing affects our purchasing decisions.
If framing effects influence our perception of the situation in a negative manner, we are more likely to make irrational decisions, which will have a detrimental impact on their financial well-being. If we are to make the best decisions, we must be attentive and remove the framing to study the raw information.
Availability
Availability bias refers to our tendency to make a decision about the future based on the information that quickly and easily comes to mind.
In this case, when someone is making a decision, information around a memorable moment can outweigh the influence on the decision. This is because information that has a strong emotional impact on us is easier to remember and recall than information that is based on facts.
For example, If you’ve had a bad experience with credit cards, you’re more likely to remember that feeling of helplessness in the future when dealing with credit cards again.
The availability bias might persuade you that you are not so good at managing credit cards, locking you in a cycle where you feel unable to make decisions. However, the easily recalled experiences are often insufficient and should not be relied on entirely when we are making future decisions, as this might lead us to make bad decisions.
One technique to counteract availability bias is to go back over the memories and dig deeper into the reason to figure out what went wrong. Even if you believe you remember everything vital, it’s a good idea to go back and review relevant facts before making a decision. It will drive us to consider facts other than our blunders in order to improve things in the future.
Few tips from Sparly to overcome biases
- Concentrate on information — In any situation that needs decision-making, concentrate on the evidence or information. Always undertake research to find relevant data to analyze each decision and its outcome.
- Reflect on your past decisions — If you’ve been in a similar situation before, dive into your memories to see what you may have done differently to achieve a better result. You can overcome your biases by learning from past decisions.
- Consider multiple perspectives — Before making a decision, try to look at the situation from a different person’s perspective. This will make you question your own viewpoints and allow you to see things more objectively.
