Four common cognitive biases – present bias, overconfidence bias, anchoring bias, and herd mentality – sabotage personal finances, according to a new review from Financial expert Hakan Samuelsson. Cognitive biases are systematic patterns of deviation from norm and/or rationality in judgment.
To combat such cognitive biases and improve financial health, Samuelsson advises implementing ‘cooling off’ period for major purchases, practising zero-based budgeting, and regularly auditing subscriptions and recurring expenses.
“Understanding the biases that drive our monetary decisions is crucial for financial success,” says Hakan Samuelsson, co-founder of Quantified Strategies, has told Digital Journal.
“These mental blind spots can sabotage even the most well-intentioned financial plans if left unchecked”, continues the expert.
Samuelsson sheds light on four common cognitive biases that might be derailing your financial success – and how to outsmart them. By recognizing these biases, you can take the first crucial step towards developing healthier financial habits.
Present Bias: The Siren Song of Instant Gratification
Present bias is our tendency to prioritise immediate rewards over future benefits, even when the latter are objectively more valuable.
This bias often manifests in everyday financial decisions. Consider this scenario: you’re offered a choice between receiving $100 today or $120 in a month. Despite the 20% return, many people opt for the immediate $100. Similarly, you might find yourself impulse-buying a new gadget today instead of adding that money to your retirement fund, even though the long-term benefits of saving are far greater.
Samuelsson’s advice: “To combat present bias, visualise your future self. Before making a financial decision, ask yourself: ‘Will my future self thank me for this choice?’ This simple mental exercise can help shift your perspective from immediate gratification to long-term well-being.”
Overconfidence Bias: When You Think You’re Smarter Than the Market
Overconfidence bias leads us to overestimate our own abilities, knowledge, and chances of success in financial matters.
This bias is particularly prevalent in the world of investing. Picture an amateur investor who believes they can consistently outperform professional fund managers and the overall market. This overconfidence could lead to excessive trading, ignoring diversification principles, or taking on too much risk – often with disastrous financial consequences.
Samuelsson’s advice: “Humility is a virtue in investing,” he stresses. “Regularly assess your performance against objective benchmarks. If you’re consistently underperforming, it might be time to reconsider your strategy and perhaps seek professional advice.”
Anchoring Bias: When First Impressions Skew Financial Judgments
Anchoring bias occurs when we rely too heavily on the first piece of information we encounter (the “anchor”) when making decisions.
This bias frequently plays out in financial negotiations. Imagine you’re discussing a potential job offer. The initial salary figure mentioned often serves as an anchor, influencing the entire negotiation process. If it’s low, subsequent negotiations tend to revolve around that figure, potentially resulting in a lower final salary than if the initial anchor had been higher.
Samuelsson’s advice: “To counteract anchoring, always do your research before entering financial negotiations or making significant purchases. Know the market rates, compare multiple options, and be prepared to walk away if the terms don’t align with your research-based expectations.”
Herd Mentality: Following the Financial Crowd Off a Cliff
Herd mentality is our tendency to follow the crowd, even when it leads to irrational financial behaviour.
This bias is often seen in investment bubbles. Take the 2024 AI stock frenzy as an example. Many investors rushed to buy shares in AI companies simply because “everyone else was doing it,” often without fully understanding the technology or the risks involved. This herd behaviour can lead to inflated stock prices and, eventually, significant losses when the bubble bursts.
Samuelsson’s advice: “Remember, the crowd isn’t always right,” he cautions. “Before jumping on any investment trend, thoroughly research the fundamentals. Understand why you’re investing and ensure it aligns with your personal financial goals and risk tolerance.”
Beyond addressing these specific biases, Samuelsson offers some less conventional tips for cultivating healthier financial habits:
- Practice financial mindfulness: Spend five minutes each day in quiet reflection about your money goals and behaviours.
- Use the ‘72-hour rule’ for major purchases: Wait three days before buying anything significant. This cooling-off period can help distinguish between genuine needs and impulse wants.
- Create a ‘money mission statement’: Write a personal manifesto outlining your financial values and long-term objectives. Refer to it when making important money decisions.
- Gamify your savings: Turn saving money into a challenge or game. For example, try the ‘52-week money challenge’ where you save $1 in week one, $2 in week two, and so on.
- Conduct regular financial ‘fire drills’: Periodically simulate financial emergencies and practise your response. This can help you identify weaknesses in your financial preparedness.
Samuelsson concludes with: “While these cognitive biases are deeply ingrained, awareness is the first step to overcoming them. The key is to create systems that protect you from your own worst financial instincts. This might mean automating savings, setting strict investment rules, or regularly consulting with a financial advisor. Other approaches you could implement are a ‘cooling off’ period for major purchases, practising zero-based budgeting, and regularly auditing your subscriptions.”
