The way our brains work can cost us a lot of money. But some of our mental quirks can be turned to our advantage.
Cognitive biases are the faulty ways of thinking that can persuade us to run up debt, save too little and make stupid investment decisions. The bandwagon effect, for example, entices us to buy the hot stock everyone’s talking about, rather than the mutual fund that makes more sense for our long-term goals. Or we sign up for a too-large mortgage because of optimism bias (“I’ll figure out a way to make the payments, somehow!”).
We can try to be more rational, but sometimes it makes sense to exploit our faulty wiring instead. Here are three money biases that you could put to work for yourself:
Money is fungible, which means every dollar has the same value regardless of how we get it or store it. But our brains didn’t get that memo, so we treat different types of money differently. We’re tempted to splurge with windfalls, for example, or to be more careful spending cash than using credit.
You can turn this mental accounting to good use by creating multiple savings accounts, each labeled with your goal for the money. For example, you could create accounts called “vacation,” “car repair fund,” “home down payment” and so on. Online banks and credit unions typically make this easy by allowing you to create and name numerous subaccounts without minimum balance requirements or fees.
Labeling and segregating money could help you keep your hands off of it. While you might dip into a general savings account for a questionable purchase, you may resist the urge if you can envision having less money for your vacation or not being able to pay for a needed car repair.
Think of the person you were a decade ago — what you thought was important, what you liked and disliked, how you behaved. If you’re like most people, you’ve changed, but you also probably think that the person you are today is pretty much who you’ll be from now on.
Regardless of their age, adults consistently underestimate how much they’ll change in the future, according to research by psychologists Jordi Quoidbach, Daniel T. Gilbert and Timothy D. Wilson, who dubbed this phenomenon the “end of history illusion.”
This illusion leads to the tattoo, mortgage or marriage you later regret. But the end-of-history illusion could be beneficial if you use it to give your future self more, rather than fewer, options.
Here’s an example: People who save for retirement often anticipate the freedom and leisure they’ll enjoy one day when they can quit work. They can’t imagine they’ll feel differently later. As they get closer to retirement, though, some realize they want to keep working at least part time for the extra money, the intellectual stimulation, the social benefits.
With sufficient savings, you typically have more options: You could quit, work part time, work full time, take a break and return to work or start your own business. If you haven’t saved, you may have little choice but to keep working.
Our hard-wired preference for short-term payoffs, even when we would get more by waiting, is known as “hyperbolic discounting.” We know we need to save more for retirement, or pay down debt, or build an emergency fund. In the moment, though, we want to spend our money in other ways.
But hyperbolic discounting can be leveraged to create good outcomes, as well.
Saving future income is also the idea behind automatic escalation. Many 401(k) plans allow you to sign up now to increase your contribution in the future by, say, 1 percentage point a year, and some plans have automatic escalation as the default. The IRS also offers a kind of “save more tomorrow” plan: You can split the direct deposit of your next tax refund, sending part to your savings account and the rest to checking.
It would be great if we were always rational and could count on ourselves to make smart decisions. Since we aren’t and we can’t, using these workarounds can help us get better results with our money.
This column was provided to The Associated Press by the personal finance
Liz Weston is a columnist at NerdWallet, a certified financial planner and author of “Your Credit Score.” Email: firstname.lastname@example.org. Twitter: @lizweston.
Liz Weston, The Associated Press