As Gen Y’s we all know that perfecting our decision-making process when it comes to our cash is an ongoing learning process. Just like our health and fitness, continued progress involves a lot more than logic and reason. After our first eye-opening goals and values session with WE, my hubby and I realised how much of who we are is linked to how we spend. And how the drive behind each purchase can be as unique as the individual.
But according to Rolf Dobelli, when it comes to our decision-making there is also a whole range of simple errors in thinking we have in common. In his international bestseller The Art of Thinking Clearly, he outlines 99 different traps we unknowingly fall into that affect our small decisions through to the big life changing and money making ones.
The chapters that stood out for me, though, the ones where I bashfully caught myself admitting to, were those affecting our financials. And being aware of these pitfalls can really add value to everything from our daily spending to taking the plunge on bigger investments.
So according to Dobelli, here’s a short list of the most common financial errors of thinking and how to avoid them:
Holding on to the past
Dobelli calls this the sunk cost fallacy. This is a classic mistake commonly made when investments such as property or shares start to plummet. Our trading decisions tend to be affected by the amount of time, money and energy we have invested into something as opposed to it’s current and future performance. We feel that if we decide to cancel a project half way through all that effort will be for nothing and we have failed.
But this is irrational thinking and can be quite costly. If we want to continue with the investment or finalise the project we need to be aware of the reasons for doing so. Rational decision making requires forgetting about the costs incurred in the past, cutting your losses and making a clear assessment of the future costs and benefits.
Falling victim to the contrast effect
Dobelli explains that we tend to judge the value of something based on what we have to compare it to. In other words, “we usually decide something is beautiful, expensive or large if we have something ugly, cheap or small in front of us.” Ever purchased leather seats in your brand new car without thinking twice? $3K for leather seats may seem minuscule compared to the $60K you just spent on your new wheels.
How about this sale, was $100 now down to $70? Sounds like a good deal, unless you go next door and see the same product for $70 every day.
This very illusion is exploited by industries daily and we tend to react by jumping at the chance without noticing our money disappearing. Instead of falling victim to these deals, do your homework. If you can get leather seats for $2.5K elsewhere either use this knowledge to bargain down the salesman or go elsewhere. And always be sceptical of ‘sale’ prices.
Blinding by the confirmation bias
Similar to forgetting your past, we tend to interpret new information in a way that supports our current viewpoint rather than seeing it for what it is. For example, if you decide property is the only area worth investing in you can find a million articles, books, and blogs to support your standpoint. But this is a dangerous practice. As Dobelli explains, “Facts do not cease to exist because they are ignored”.
Our brains tend to view any disconfirming evidence as “exceptions” to continue supporting our theories. And becoming blind to contradictory evidence is the quickest way to unproductive thinking. Instead, we should view exceptions as reasons to pay attention and, as difficult as it may be, question our own theories. That’s where the biggest growth and learning comes from. After all, “the real fault is to have faults and not to amend them” – Confucius.
Bowing to authority
According to Dobelli, following authorities poses two main problems to clear thinking; firstly their track records aren’t great as they usually adhere to the theory of “we’ve always done it like this” therefore they automatically challenge new ways of thinking. And secondly, authorities crave recognition and constantly find ways to reinforce their status which again restricts change. The most amazing innovations to date were the result of going against the normal ways of thinking imposed by authorities.
Therefore, when in the thick of decision making, think about which authority figure may be influencing your reasoning and try to remove them from your process.
Overestimating your knowledge and abilities
Now this might sound like it’s going against the positive, ‘you can achieve the impossible’ mantra us Gen Y’s chant on a daily basis but hear me out. Overconfidence in forecasts such as stock performance or the time and costs involved in projects such as renovations can be very costly. We don’t usually hear of projects that were completed in less time or at a lower cost than predicted as we tend to overestimate these factors.
A can-do attitude is very powerful but more so when combined with clear judgment. Therefore by being aware of these overestimations, as well as being sceptical of predictions, we can better equip ourselves for worst case scenarios and ensure our sunny outlook isn’t affecting our judgments but rather fuelling our progress. In other words, include a small buffer when it comes to planning these projects that way if things go pear shaped you’ll have something to fall back on.
Becoming attached to things
Dobelli calls this the endowment effect. We consider things to be more valuable the moment we own them. In other words, if we are selling something, we charge more for it than what we ourselves would be willing to pay. Ownership makes us increase the selling price and a perfect example of this is when someone decides to sell their house. The emotional attachment to their home causes them to, more often that not, overestimate its value. Now, this may encourage the agent to push for a higher price which is great if it can eventuate but basing plans on this usually inflated figure can be risky. The important lesson here is not to cling to things when it comes to putting a financial value on them. Dobelli suggests assessing their worth without the emotional attachment.
Falling for the scarcity error
Rare is valuable. If something is difficult to acquire we seem to want it more. When we see an opportunity disappearing we tend to want to grab it before it does. Similar to the contrast effect, if there is a potential shortage of supply in our minds or we are deprived of an option we suddenly deem it more attractive. In psychological terms, this is called reactance, and the typical response to this type of scarcity is a lapse of clear thinking. And retailers use this all the time. ‘Only while stocks last’ or ‘Today only’.
As Dobelli points out, we should be assessing products and services solely on the basis of their price and benefits. It should be of no importance if an item is disappearing fast.
Applying the anchor effect
Whenever we have to guess something we’re unsure of we use anchors. We start with something we do know and work from there to an educated guess. The problem is, the anchor is usually misleading or based on data that’s irrelevant to the topic at hand. For example, the RRP of a sale item is usually the base point we use to decide if the sale is really a good deal. But the RRP in most cases has been inflated to make the sale price more appealing.
Sales professionals rely on this technique all the time. A real estate agent may claim he has been given an offer on a property of interest to you for an exaggerated amount. Let’s say he claims this offer is $1.5 million, your willingness to pay more will most likely increase even though the market rate is probably closer to $1 million. These anchor tactics are no secret but that doesn’t make them less effective. And the more uncertain we are of the value of something, the more susceptible we are to these anchors. So again, do your homework.
Avoiding these judgment errors may seem like common sense but when we decide on a purchase that goes against our goals and values, chances are we have stepped into this way of thinking to justify our spending. Being aware of these pitfalls can add value to even the smaller day-to-day purchases we make and at the very least, bring a little more awareness to our spending habits and identify where we can improve.
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Article by Evie Tramer
Disclaimer: all information contained within this article is of a general nature and should not be relied upon when making financial decisions. Please consult a professional financial advisor or planner (like us!) before acting.