This is an excerpt from End Financial Stress Now: Immediate Steps You Can Take to Improve Your Financial Outlook by Emily Guy Birken. Used by permission of the publisher, Adams Media, a division of Simon & Schuster. All rights reserved.
Emily Guy Birken (WI) is the author of three books: Choose Your Retirement, The Five Years Before You Retire, and Making Social Security Work For You. She is a mother, humorist, and self-described “mensch”. She has appeared on NextAve and Wisconsin Public Radio, and has contributed to Woman’s Day, Redbook Magazine, O, The Oprah Magazine, US News & World Report, Money Magazine, Yahoo! Finance, Business Insider, Wise Bread, PT Money, The Dollar Stretcher, Money Crashers, as well as many other personal finance publications. You can follow her on twitter or facebook.
WHAT YOU’LL LEARN IN THIS CHAPTER:
• A cognitive bias is a systematic error in logical thinking.
• Such biases are common and even predictable, but it can be very difficult to detect cognitive biases in your own thought patterns.
• Seven of the most common cognitive biases are likely behind some of the counterproductive and stress-inducing financial behavior you engage in.
One of the astonishing things about the human brain is its ability to make quick decisions based upon huge amounts of random data. We do this in part through the use of what are called heuristics—mental shortcuts that allow us to make fast and efficient judgments. Without these
mental shortcuts, we would be bogged down by all the calculations necessary to make decisions.
For example, let’s say you’ve picked out some clothes at a store: a pair of jeans priced at $39.98, a shirt priced at $29.97, and a scarf priced at $19.95. You have about $100 in cash—$95, to be exact. How would you determine if you have enough money to cover your purchase?
While the most precise method of answering that question would involve adding the exact amounts together, it’s much more likely that you would round up each price and add the approximations. It takes a heck of a lot less time to do this than it would for you whip out paper
and pencil or a calculator, and the approximation will give you a useful answer. The heuristic of rounding prices helps you to determine that the $100 or so in your wallet will cover the approximate $90 cost of your new clothes.
Heuristics smooth out difficult decision-making processes, meaning you do not have to overload your brain with information and calculations every time you need to make a decision. The problem with heuristics is that they can sometimes result in a cognitive bias.
Cognitive biases are systematic errors in logical thinking that can lead to poor decisions. We are all vulnerable to cognitive biases because the heuristics we use to approximate answers are more like rules of thumb rather than absolute truths. But our brains have trouble recognizing
when such a rule of thumb is leading us astray.
For instance, let’s go back to the clothing store. The total of your purchases equals approximately $90 ($89.90, to be exact). You know you have about $100 in your wallet, so you stride up to the register, prepared to pay. But the rounding heuristic did not take into account the 7 percent sales tax on your purchase, or the fact that you are thinking of the $95 in your wallet as “about” $100. So when the total comes to $96.19, you feel foolish when you realize you are more than a dollar short of the total purchase price. The rounding heuristic gave you an informal sense of how much you would owe at the register, but it became a cognitive bias when you failed to recognize that the amount you calculated was not exact.
Cognitive biases affect every part of our lives, from our work habits to our political beliefs, and they can be very difficult to recognize. Unfortunately, cognitive biases can often lead to irrational money behavior that adds to your financial stress. Though researchers have identified dozens of cognitive biases (and have theorized, but not necessarily proven, even more), the following seven biases are among the ones most likely to negatively affect your financial behavior.
Hedonic adaptation describes the phenomenon wherein we get used to the things we have. Think of the pleasure and pride you felt upon first purchasing your car. I’m guessing your delight in your new vehicle faded before the new car smell had completely dissipated. This happens because our brains are wired to get used to things fairly quickly.
This can be both good and bad. In 1978, researchers from Northwestern University and the University of Massachusetts asked recent lottery winners and recent paraplegic victims of catastrophic accidents about their levels of happiness. As you might expect, the lottery winners
were happier than the accident victims immediately after their life-changing events. However, both groups returned to their average level of happiness within two months. They got used to their new normal, which meant they were about as happy as they were before their lives changed.
For most of us, hedonic adaptation is not the result of a major life change. It merely means that no purchase or consumer good will permanently satisfy us. Unless we truly examine the reasons why we are making purchases, we are likely to keep reaching for another thing to buy that will offer momentary pleasure. However, each new thing will quickly become old hat, prompting another purchase.
Hedonic adaptation is why it is so easy for a major pay raise or other financial increase to land you in the same financial stress you felt at a lower level. When the purchases that were rare treats when you were poorer become a standard part of your life, you enjoy them less. The
upshot is that you will be loath to part with them now to improve your financial life, because they are part of your new normal. This is why behavioral economists have started referring to hedonic adaptation as the hedonic treadmill—you have to keep running faster and faster just to stay in the same place enjoyment-wise.
COMBATTING HEDONIC ADAPTATION
Researchers studying the science of happiness have found that there are two ways to control the sense of hedonic adaptation. The first is through gratitude. Regularly expressing gratitude for the things in your life can help you feel both more optimistic and happier, according to Robert A. Emmons, professor of psychology at the University of California, Davis. That increased happiness can help end the constant search for pleasure through purchasing, which is what the hedonic treadmill represents. According to Emmons, a gratitude journal, wherein you regularly
record things for which you are grateful, can help you improve your mood, as well as your physical and social well-being.
In addition, spending your money on small and regular pleasures will provide you with greater satisfaction than you would feel by saving all of the money up for a larger indulgence. Hedonic adaptation means you will soon become accustomed to the new car or the week at the
beach. However, having a standing movie date with your best friend every Saturday will be something that you get to enjoy over and over, and look forward to throughout each week. Hedonic adaptation will not have a chance to rob you of your pleasure in enjoying your favorite films with your favorite person.
How strong do you think you would be in the face of temptation? Most people believe they are perfectly capable of ignoring temptations—but then they find themselves falling off the wagon as soon as their control is tested. This common cognitive bias is known as the restraint bias, and it’s related to illusory superiority.
Most people tend to overestimate their own impulse control. They believe they will be able to show more restraint in the face of temptation than is realistic. This is why your grand plans to lose twenty pounds are often derailed by the first box of donuts you see. You have overestimated your ability to be virtuous in the face of temptation.
The restraint bias is often the culprit when you find you cannot maintain the resolution (or budget, or schedule) you have set for yourself. When you are in the midst of planning the new resolution, budget, or schedule, you are certain that you’ll be able to restrain yourself around your temptations and that you’ll be perfectly capable of handling all of the issues that may come up under your new rules. Unfortunately, you will be just as flawed and human in the future as you have been in the past—but the restraint bias will keep you from remembering that fact.
COMBATTING THE RESTRAINT BIAS
In the Greek epic The Odyssey, Odysseus longs to hear the dangerous song of the sirens, who use their enchanting voices to lure sailors to their deaths. Odysseus plugs his crew’s ears with beeswax and has them tie him tightly to the mast of his ship. This allows him to hear the sirens’
song without having the ability to steer the ship off course.
Odysseus’s example shows us how to combat the restraint bias. If you know ahead of time that you will be tempted, set up your life so that you cannot make the poor decision once temptation strikes. We will talk in Chapter 12 about ways to do this.
The more pernicious issue with the restraint bias occurs when you don’t know that you will be tempted. Though unexpected temptations will always crop up, you can help mitigate both the restraint bias in general and the hot-cold empathy gap in particular by keeping a daily journal while you work to improve your finances. In each entry, jot down how you felt when you made decisions, particularly the decisions you are most or least happy with. Over time, you will begin to see the emotional and thought patterns that repeat as you make your best and worst decisions. Once you know when you are most tempted and what is most likely to lead you into temptation, you will be in a better position to avoid those situations.
The Hot-Cold Empathy Gap
Researchers have found that our restraint bias is often triggered by something known as the hot-cold empathy gap. This gap is a cognitive bias that leads you to underestimate how much your visceral needs (like hunger or lust) and/or your state of mind (like anger or frustration) will influence your behavior. For instance, if I were to ask you right after dinner if you will have any trouble bypassing the office donuts the following morning, you will probably answer that you won’t. When I ask the question, you are full and satisfied from dinner, which means you are imagining yourself the next morning feeling the same way. By the time morning comes, however, you may be hungry or tired, which will make you much more likely to grab a chocolate glazed donut than you could have anticipated when you were full and alert.
The Spotlight Effect
In 2000, researchers at Cornell University asked fifteen undergraduate students to don a T-shirt featuring a photograph of the singer Barry Manilow (whose coolness quotient had definitely dipped since the release of “Mandy”) before going into a room full of strangers.
The Cornell researchers then asked the Manilow-wearing participants to estimate how many of the strangers in the room recognized Barry’s smiling face. The participants, feeling embarrassed by the T-shirt, predicted that about half of the other students in the room would identify the face on their shirt as belonging to Manilow. In reality, less than 25 percent of the strangers in the room recognized who was on the shirt (and I’m assuming they were all humming “Copacabana” to themselves).
What’s going on here is something called the spotlight effect. This is the cognitive bias that leads you to believe that people are noticing you more than they really are. Wearing a T-shirt emblazoned with Barry Manilow can be so embarrassing to the wearer that it seems impossible
to believe other people won’t notice it. However, other people don’t notice—because they are too busy feeling mortified about the pimple on their chin or the hole in their shoe.
The spotlight effect can have a big effect on spending if you worry that other people will notice your spending habits. For instance, many young professionals believe they must own a nice car in order to do well in their careers. That belief is based upon the idea that their superiors, coworkers, or clients are judging them by what car they drive.
Unless you have a job such as a real estate agent, which involves clients getting into your car, it’s likely that no one even knows what kind of vehicle you drive. Even if you do work as a real estate agent, people are much more likely to notice that your car is clean and well-kept than recognize how new or expensive it is.
A similar problem occurs when people find they need to downsize in some way. If you are worried about what people will think if you move to a smaller home or let your membership to the club lapse, it can be very easy for you to maintain unnecessary and unsustainable spending just to keep up appearances.
COMBATTING THE SPOTLIGHT EFFECT
We all believe we are the hero of our own movie, which makes it difficult to remember that other people are not paying as close attention to us as we believe. The best way to combat this effect is to adopt something sociologist Martha Beck calls the universal question: So?
Asking yourself “So?” is useful because it both helps you to remember that people are not paying as close attention as you think they are, and it helps you to put the issue in context. Does whatever you are embarrassed about really matter?
Here is how you might use Beck’s universal question:
“Everyone will see that I bought a ten-year-old used car.” So?
“If we downsize, people will think we couldn’t afford our mortgage.” So?
This thought exercise can help you to re-contextualize the financial decisions you make based on embarrassment or shame, since it helps you remember that no one is paying attention and nothing bad will happen if you change your habits.
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It’s always important for an individual to assess his financial strength before making big purchases. Even while repaying, he needs to stick to his payment plan. It certainly requires you to understand your financial situation and develop strategies accordingly.
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Oh my goodness I juts loved this specially the Manilow experiment – psychology and money spending are so interesting and so useful!
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