4 Cognitive Biases That Can Cost You MoneyIt doesn’t take much life experience to understand that human beings aren’t completely rational. Our brains aren’t perfect decision-making machines that always pick the objectively best option, and we make a lot of choices based on how we feel. In fact, there are certain bad choices that people in general are especially prone to making, thanks to kinks in our thinking called cognitive biases. Cognitive biases are recurring patterns of thought that lead us to illogical conclusions, and they can cause you to make serious blunders when it comes to managing your finances. To learn about four cognitive biases that may be holding back your financial potential and how to avoid them, keep reading.

Sunk cost fallacy

If you’ve ever heard the saying “don’t throw good money after bad,” then you may already have a basic understanding of the sunk cost fallacy. In economics, a sunk cost is a cost that you’ve already paid and cannot recover. From a completely rational perspective, since you have no hope of getting the money from a sunk cost back, it shouldn’t affect your decision-making at all. Because of the sunk cost fallacy, though, instead of just cutting your losses and moving on from a bad financial decision, you may throw more money at a problem because you want to make the money you spent earlier more worth it. Essentially, it’s your brain telling you “we can’t stop spending money on this because look at all the money we’ve already spent on it!”

The sunk cost fallacy is one of the most common cognitive biases you’ll encounter in personal finance. For instance, you may know someone who spends a lot of money repairing a car that breaks down constantly just because they’ve already spent so much money fixing it up, even though getting a new car would ultimately be the cheaper option for them. Even large companies and governments can fall victim to it. One of the go-to examples to demonstrate the sunk cost fallacy is the case of the Concorde, a failed supersonic jet that the British and French governments spent huge sums of money developing for years and years, mostly to justify the money they had already invested in it.

To stay clear of the sunk cost fallacy, try to understand that you are not a hostage to your past decisions. Realizing that your past costs were wasted stings, but what’s important is the future value of your choices. Everyone makes bad financial calls from time to time, and it’s smarter to admit your losses and change course instead of doubling down and losing even more.

Status quo bias

While some people have adventurous spirits, by and large humans tend to prefer what’s familiar to them. When faced with a choice between changing things up or sticking to the same course, people are very likely to choose the latter option due to a tendency called status quo bias. Status quo bias makes you overvalue your current state of affairs when compared to alternatives, and while that’s good for making sure you’re satisfied with your life, it can also stop you from enacting positive changes. As an example, a large number of Americans have stuck with the same credit card for over 10 years, even though many modern cards offer generous intro bonuses and rewards.

When you’re deciding between several options, try to weigh all of your choices according to their benefits and drawbacks, including the choice to stick with what you already have. It may help you to draw a comparison table and write down your thoughts in order to organize them and see the situation more clearly. Stubborn commitment is no good reason to pass up financial improvements.

Optimism bias

Just as humans seem to be wired to prefer the familiar, most people are also incredibly optimistic when thinking about their own personal futures. This bias toward optimism is useful in a lot of ways, as thinking positively about your life can lower your stress, keep you healthier and help you earn more money, but like all cognitive biases, it also comes with some downsides. Seeing the future with rose-colored glasses can make you think you aren’t as prone to risk as other people, which may cause you to ignore crucial saving steps, such as saving for retirement or building an emergency fund. It can also influence you to assume you’ll have more restraint than you actually will. A study by the Reserve Bank of Australia found that most people who pay credit card interest did not consider their card’s APR when they chose it, including people who already paid credit card interest regularly. This suggests that many people underestimate their chances of paying credit card interest when choosing a new card.

Optimism bias is tricky to shake off since staying positive comes with so many advantages. However, you also need to be realistic, taking your past actions and tendencies into regard when making financial decisions. Until you make a concerted effort to change your habits, assume that future you will behave a lot like past you did.

Anchoring effect

Hypothetically, imagine you’re going to a store to buy a chair for $100. While you’re at the store, you learn that the same chair is on sale for $50 at another store 10 minutes down the street. Would you make the trip to save $50? Most people probably would. Now let’s imagine you’re going to a store to buy a whole furniture set for $5,000, and then while you’re at the store, you learn that the same furniture set is on sale for $4,950 at another store 10 minutes down the street. Would you still make the trip to save $50? Even though in both situations you’re traveling 10 minutes away to save $50, they feel very different from each other because of the context of the money involved. When you’re thinking about spending $100, $50 sounds like a whole lot of money, but when you’re thinking about spending $5,000, it only feels like a drop in the bucket.

This is the anchoring effect, a cognitive bias where you focus too much on one piece of information (usually the first piece of information you received) when making a decision. The anchoring effect most often bites you when you’re shopping for big ticket items, such as vehicles and appliances. When you’re dealing with big numbers, don’t lose sight of what a dollar means to you, and try to take advantage of things like price matching or rebates to bring your costs down even just a little bit. This also applies to when you’re saving, too. Take a page from the early retirement community and make sure you do everything you can to increase your savings by one or two percent, such as using a cash back credit card when shopping or keeping your money in a high-yield online savings account.

Cognitive biases are difficult to overcome, but now that you’re aware of your biases you can more easily take them into account when you’re making financial choices. For more advice on how to handle your money the sensible way, follow our personal finance blog.