You may not be aware of the fact that when it comes to making decisions that affect your financial future, there is a high chance that some of your decisions are driven by cognitive biases. Cognitive biases refer to errors in your logical reasoning process. These errors occur as a result of certain factors. In this article, you will be introduced to three cognitive biases that may be costing you money.
Cognitive biases refer to errors in your logical reasoning process.
1. Anchoring Bias
The anchoring bias refers to a flaw in reasoning where you are inclined to make a decision based on the initial information you encounter pertaining a certain matter. For instance, if you are looking to buy a car, you are more likely going to make a decision on price based on the first amount that you are told about.
The costs of other cars you look at will be measured against the first value you heard, whether it was an accurate representation of the value of these cars or not. This bias can cost you money because you might feel you are making the most logical decision but you actually aren’t.
2. The Bandwagon Effect
The bandwagon effect simply refers to following the current trends. Many of us are likely to make decisions based on what those in our immediate circles or in popular culture are buying. Before spending money on anything, make sure you really need it and are not being influenced by irrelevant external factors.
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3. Sunk-Cost Fallacy
This cognitive bias is one where people are likely to proceed with an action because they have already put in a certain commitment, such as time, money or effort beforehand. This bias does not put into account whether the subsequent decision to uphold the original commitment is the right one.
For instance, if you spend 500 dollars to start a new business, you are more likely to invest a further 500 into the business even when you are not sure of the success of the project. In order to avoid falling into this trap, consider all resources spent as gone and do not let them affect further decisions. Sometimes, it is better to take a small loss than to proceed and end up with an even bigger loss.
These cognitive biases can be avoided by ensuring you conduct adequate research before making an important financial decision or a large purchase. This will help you make sound financial calls as well as help you to avoid making investment mistakes.
