Having money and spending it, in effect, is all about opportunity cost. When you spend it on something, you're being denied the opportunity to spend that money on something else. If we were to simply stop and think of what we could have bought with that money we just spent on that new handbag, we'd probably be in a deep, dark place.
Simply put, the choices we make in spending money isn't exactly as straightforward as we think it is. Here are the common pitfalls and traps that we do to fool ourselves with money.
1. Mental Accounting
Mental accounting is when we choose to treat a certain amount of money with more care and protection than others. For example, perhaps you've wanted to go on a vacation for a long time. So, a special account or 'jar' of money is set up where you deposit a certain amount of money into it every week or month. However, when rent or school loans start calling, and you need that money to pay off the debt, you refuse to touch even a single cent of that money, hell-bent on using it ONLY for your vacation.
While it isn't necessarily a bad thing, this can put your finances in a tight spot, especially when it comes to paying off loans and servicing debts that are more urgent.
However, mental accounting can also be used to our advantage as well. For example, say you're trying to save enough money to start a new account for investing in stocks (you can see that too here!), you will dramatically save more. Better yet, when that money has been deposited into the brokerage firm, and you start making more returns on that investment, you'll be much more motivated to keep saving more to add on to your positions!
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2. The 'Anchoring' Effect
The anchoring effect is when we try to estimate the value of something based on a rather irrelevant piece of information, which is the anchor, such as the amount of money you paid for it, or what someone else says it is worth.
For example, if you bought a stock for $30, you might anchor the value of the stock around that price, i.e. if the stock goes up to $35 it's doing well, and below $30 means it's bad. For our readers who have been around and doing some trading, we all know that that it isn't how the stock market operates.
So how we can stop this would be to watch ourselves – particularly our emotions, especially when we are upset or more depressed over things. Make sure that logic would rule the decisions, especially when it comes to matters of financial importance!
3. Present Bias
Present bias, to put it very simply, is the difficulty in postponing immediate returns, i.e. delay instant gratification. It is human nature to opt for the choice that is tempting to do now, over a choice that makes us wait longer for gratification, even if it benefits us greatly in the long run.
Present bias is mostly based on emotion. When we're sad, do we immediately think of why we're sad? I would say most of us would either reach for some ice cream to calm ourselves or watch TV. If you were offered $100 now vs. being given $1000 after a month of waiting, I'm pretty sure the majority of us would simply take the $100 immediately.
So how can we stop fooling ourselves with money because of present bias? Since the bias is based rather closely on emotion, it would be good for us to check ourselves before making the decision.
A good practice would be to calm ourselves down when we're feeling emotional. Take a walk outside or do something else that takes away the distraction of emotion. When we're more level-headed, then we can come back to the decision and make the best choice for our careers.
4. Familiarity Bias
It is also human nature that we gravitate more to the things we know than explore something we don't. For example, we tend to eat at the same places or pick the same stocks over and over rather than explore for a new place to eat, or do fresh research on new stocks that could offer better returns.
Even some company employees are guilty of this – they would rather buy their own company's stock over another simply because they are more familiar with its workings.
Again, while not a bad thing, it could mean financial ruin if you're not careful! Investing in your own company's stocks isn't a bad thing if the financials are going strong. The danger is when you're simply investing simply because you're comfortable with it.
How do we overcome this?
Unfortunately, the way to overcome this is through sheer force of will, especially if it has developed into a habit.
If you feel you've been in a rut and doing the same thing over and over, a conscious effort must be made to explore a new place to eat. You must force yourself to see into the massive world of stocks and start researching on the fundamentals of whatever company you've picked as a potential candidate with good returns.
The steps to overcome familiarity bias is a long, tough road, but ultimately the most rewarding thanks to the new opportunities and options that you'll get in return.
This article first appeared on The New Savvy.