Behavior plays a big role in personal finance. In fact, there’s a whole field of study called behavioral finance that’s dedicated to figuring out how psychology affects our money decisions. Although we all have different personalities, there are some negative behavioral tendencies and biases humans share that influence how we approach personal finance. Here are 4 psychological principles that could be working against you if you’re trying to save money and build wealth.
The Diderot Effect
Have you ever read the children’s book If You Give a Mouse a Cookie? The story is about a boy who gives a mouse a cookie, which causes the mouse to want milk to go with it. Then once the boy gives the mouse milk, he wants a drinking straw, which leads to a slew of other requests.
The Diderot Effect is very similar to the mouse’s story. Whenever we buy something new, it has the potential to cause a spiral of consumption. For example, if you buy a new dress, you may think you need a new pair of earrings and shoes to match it. Or if you buy a new house, you might feel like your current furniture doesn’t fit the space, so you have to replace most of it. Starting a new hobby can also cause you to purchase a bunch of supplies that may go unused if you decide you don’t like the activity.
I’ve found that a good way to prevent the Diderot Effect is to adopt a minimalist mindset. Imagining how cluttered my home would be if every purchase set off a consumption spiral prevents me from going overboard. Being grateful for what you have can also help ward off the Diderot Effect.
You’ve probably heard of price anchoring, which is a tactic that retailers use to make consumers comfortable with spending more. For example, outlet and discount stores often include a “suggested retail price” on the tag to make the price they’re actually charging seem like a bargain. This works because of a psychological principle called anchoring bias.
Anchoring bias is the tendency to disproportionately base our decisions off of the first piece of information we receive. So if you walk into a store and see a TV that costs $1,000, your brain will use that as a reference point to judge the rest of the prices against. Suddenly a $500 TV doesn’t seem like a bad deal because your brain is comparing it to that first $1,000 flatscreen you saw.
Anchoring Bias Affects Investing Decisions
Although anchoring bias affects us heavily when we’re shopping, it can also impact other areas of our finances according to CNBC. For instance, employees who have workplace retirement plans often view the employer match amount as an anchor on a subconscious level.
This anchoring bias may cause employees to contribute just enough to get the match, which could jeopardize their retirement plans. Many employers only match 3% of your annual salary, and contributing just 6% of your salary to retirement usually isn’t enough.
To prevent this anchoring bias, Google sent an email to their employees suggesting a much higher contribution amount of 10% to 20%. As expected, this email boosted employee contributions, showing just how much anchoring bias can affect personal finance decisions.
The best way to prevent anchoring bias is to challenge your financial assumptions. Ask yourself why you think you should contribute 10% to retirement or pay $1,500 for rent. Doing your research and comparison shopping can ensure your personal finance decisions aren’t being affected by anchoring bias.
Another psychological tendency that can affect your investing decisions is recency bias. People often place too much importance on recent events when making financial decisions. In a down market, many retail investors assume that prices will keep going down and sell off stocks to avoid incurring more losses. However, history shows that it’s better to hold on to your investments when the market is down, because the stock market usually recovers eventually.
On the flip side, investors may believe a recent stock market rally will continue and make trading decisions based on that assumption. But past results don’t guarantee future returns. Just because the market or a particular stock has performed well recently doesn’t mean that trend will persist.
This kind of short-sighted behavior and decision-making can hurt your finances. It’s usually better to stick to a long-term investing plan than to react to the volatile swings of the stock market. Trying to time the market rarely works out and could cause you to lose money. Instead, financial experts typically recommend that investors make a long-term investing plan based on buying and holding more stable assets like index funds.
Do you know of any other behavioral tendencies that affect people’s financial decisions? Share them in the comments below!
Vicky Monroe is a freelance personal finance and lifestyle writer. When she’s not busy writing about her favorite money saving hacks or tinkering with her budget spreadsheets, she likes to travel, garden, and cook healthy vegetarian meals.