To paraphrase a really old song – you probably don’t think this post is about you. No one likes to think they make money mistakes. If you don’t think it applies to you, you are most likely suffering from one of THE MOST COMMON mistakes your brain is hard-wired to make. In
Overconfidence leads us to believe we are smarter about things than we really are, especially about money. So read on, especially if you don’t think you need to. When you recognize yourself I promise not to say “I told you so”.
Why should you care about these mental mistakes?
Not only is your brain hard-wired to make them, but marketers are working overtime reinforcing them to extract more money out of your and/or your business. You may even work to reinforce them for your audience and customers. Fair enough. Just don’t make the mistake of thinking that because you use them on other people you are immune to them. That’s overconfidence again!
This is NOT a comprehensive list – just a brief romp through the myriad ways our minds deceive us and how it costs us money every day. Get your arms and hands inside the tour bus – here we go!
We’re blind to our blindness. We have very little idea of how little we know. We’re not designed to know how little we know.Daniel Kahneman
Mental accounting is the inclination to organize and handle money differently depending on where it comes from, where it is kept, or how it is spent.
Example: You go to the casino with $100 and win up to $1800. You keep gambling and come home with $500. Did you win $400 or lose $1300?
If you said you won $400 you are ignoring the fact that you could have come home with the full $1800. Even though you may never have touched it, it was in fact yours. But because it was “free money” you think of it differently than the money you started with, which you consider yours.
In America, it’s not important how much an item costs. It’s more important how much you can save when you buy it.Anonymous
First, stay out of the casino! Beyond that, though, treat every dollar as if you had earned it. The $1300 was just as much yours as the $100 you came in with so to think rationally about it you must treat it as a loss.
You fall victim to the sunk cost fallacy when you make decisions based on what you’ve already invested (time, energy, or money) rather than on the future costs and benefits of a continued investment.
Example: You keep paying to repair an old car even though the value of the car doesn’t warrant putting more money into it. Or, to use a non-financial example, you stay in a bad job because you’ve already given 2 years of your life to it and you don’t want to “waste” those two years.
In your business you stick with an old website because of how much you paid for it, even if it isn’t working anymore. You do things yourself that you could delegate or hire out because you’ve already spent so much time on it you’re determined to finish it.
Don’t cling to a mistake just because you spent a long time making it.Unknown
Ignore what you’ve already invested. Ask yourself whether you would make the transaction, enter the relationship, take the job, or choose the career if you were starting fresh and had no investment in it.
This hard-wired mistake leads us to resist change even when it is in our best interest.
Example: In one research study, when subjects were given 3 choices of investments, 1/3 of them chose municipal bonds. But in a scenario involving the same 3 choices, if subjects were told they already owned the municipal bonds 50% decided against selling them.
In other words, we tend to resist change. This can look a lot like the sunk cost fallacy, but this one is different because it isn’t based on what you’ve invested in the old system. It is just based on the effort of making a change – any change.
Change doesn’t always mean progress, but the status quo isn’t always the best result, either. It is merely the most convenient.Harsha Bhogle
This one is difficult to overcome, but you can use it in your favor. Make your desirable financial actions automatic, thus making them the status quo. For example, make your savings deposits automatic.
Another way to loosen the grip of the status quo bias is to assume you are in a different position than you are. Imagine you are in the market for a new car and you’ve always bought a Honda (you’re my people). Status quo bias would lead you straight to the Honda dealership to buy another one. If you read Consumer Reports and it says Toyotas are a better buy this year, you’re liable to discount that information. Try approaching it from a different perspective. Imagine you are given a new Accord and a new Camry, but you can only keep one. Which one would you sell?
The anchoring effect happens when you get a number stuck in your head irrationally and it affects your decision.
Example: “Everyone” knows that the appropriate amount to spend on an engagement ring is two month’s salary. But do you know why? This is actually an arbitrary number promoted by the diamond industry.
The appropriate amount to spend on an engagement ring is what you can afford.
First impressions are most lasting.Proverbs
Another example of the anchoring effect is the sticker price of that new Accord. The sticker price sets the basis for the negotiations, but it is really an arbitrary number. All is represents is how much profit the dealer wants to make on the car. The dealer’s cost is a much more relevant number since it represents what the dealer actually has invested in the car.
The monthly payment is another example of the anchoring effect. The dealer will get you focused on this number and hope you forget about how many months you’ll be paying that payment. “But it’s only $450/month!”
This is another mistake that is difficult to overcome, even when you know it is happening. Your best bet is to choose your own anchor. For examole, rather than allowing the dealer to negotiate down from the sticker price, make him negotiate from his cost.
This is somewhat related to the status quo effect. It happens when you value something differently depending on whether you are buying or selling it. Essentially it is overvaluing what you already own.
This plays out in yards all over America every sunny weekend when people put higher prices on their “stuff” than anyone would ever pay. (This is also the anchoring effect as the seller remembers what they paid for the item when it was new and tends to think it is still worth that.)
Example: In one research study some subjects were given coffee mugs and the others received nothing. The mugless subjects were only willing to pay $2.75 to get one of the mugs but the mug owners would not sell for less than $5.25.
Have you ever noticed that their stuff is shit and your shit is stuff?George Carlin
Knowledge is power and the best way to avoid the endowment effect is to acknowledge its power. If you aren’t an expert on whatever you are buying, ask one. If you are an expert, ask another one. Part of the danger of the endowment effect is that we also value our knowledge more highly than that of others. This is one reason we make those decisions where we later say “I should have known better”.
Sometimes it is just easier to go along with the crowd and humans evolved to stay part of the crowd. As a basic survival strategy, it worked pretty well. Everyone “knows” there is safety in numbers, right? Financially, though, that isn’t necessarily true. Interestingly, while crowds are more responsive to change than individuals, they are NOT necessarily more logical. You are actually MORE likely to make a money mistake when you blindly follow the herd than if you do your own research.
Example: Most of the examples of this mistake are related to the stock market. Selling when everyone else is selling is an example of the herd instinct. Falling prices would be a signal to buy in any other circumstance (your favorite store is having a sale). By selling in a falling market people
If everyone is thinking alike, then someone isn’t thinking.George S. Patton, Jr.
You can insulate yourself from the herd instinct by making firm rules for yourself and sticking to them. Do your own analysis by never passively accepting information in its original package. Transform “the stock market dropped 200 points” to “the stock market dropped x%”. Transform “only $22/month” to “$407 over 18 months instead of the $299 it would cost today in cash”. To really stretch, get financial advice from someone you trust who doesn’t mind disagreeing with you. Assign them the task of shooting down your ideas and challenge them to prove you are making
You make the mistake of confirmation bias when you treat kindly or are overly impressed by information that confirms your initial information or preferences. On the flip side, this means that even if evidence is presented that conflicts with your bias, you will dismiss it or view it as an exception to the rule.
Example: If you believe that used cars offer a better value you probably won’t even look at a new car. Articles that suggest that a new car may be a better value under certain circumstances will be viewed with suspicion. You’ll give more weight to articles and opinions that support buying a used car. At the same time, you’ll downplay or attempt to disprove the ones that support buying new.
We think, each of us, that we’re much more rational than we are. And we think that we make our decisions because we have good reasons to make them. Even when it’s the other way around. We believe in the reasons, because we’ve already made the decision.Daniel Kahneman
Unfortunately knowing about confirmation bias doesn’t help you avoid it.
Avoid confirmation bias by deliberately seeking out the opinion of someone you respect who disagrees with you. Learn to examine your own thinking by identifying the assumptions you are making and try to prove yourself wrong. The skills of emotional intelligence – self-awareness and self-control – are also useful in avoiding confirmation bias.
Of course, there are many nuances to these mental money mistakes that cost you money every day. As you recognize them it gets easier to fight back. Here are my best strategies in an easy to use list:
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OK, now you’ve got some great strategies for thinking about your money AND you’ve got a simple tool to use “in the moment” to help you stick to the decisions you make when you plan your budget.
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