Did you know that creating wealth has everything to do with your mindset? The gist is, your day-to-day decisions revolve around certain pre-existing psychological factors that affect most of your money decisions. These components determine how you spend, save, and even invest your money. Check out the list of 10 factors below to see which are already affecting your finances and of course which to avoid!
Number 1: Anchoring Bias
The first psychological factor is anchoring bias, and it refers to the tendency of holding onto first impressions. Usually, people tend to believe the first piece of information they come across and changing this habit can be difficult, if not impossible. As a result, they base future decisions on their first point of inference even though it was inaccurate. If you do this, chances are high that you’ll end up with a crooked decision-making process simply because you favored the first information you came across.
To put it into perspective, let’s assume you’re planning to buy a car. So after asking around, the first person you ask tells you that your ideal car’s average price is $30,000. With that in mind, you head to the dealership, and when you get there, the car seller informs you that the cost of the car you want is actually $28,500. Being $1500 cheaper than what you expected, you think to yourself -’This must be a great deal!” Being offered a price that saves you money sounds like a dream, right? And so you pay for the car without knowing that there’s another car dealership selling the same vehicle for $23,000.
Visible from the example above, anchoring bias can significantly affect your spending habits. You may end up paying more and skimping on good deals simply because you didn’t take time to shop for more economical alternatives.
The good thing is, anchoring bias can work to your advantage. During negotiations, being the first to lay your cards on the table can set the whole negotiation process’ pace. Particularly with salary negotiations and business deals, anchoring bias will help you get the more financially rewarding results.
Number 2: The Bandwagon Effect
Also known as the herd mentality, the bandwagon effect is a critical psychological factor that will affect your wealth. Essentially, the bandwagon effect is the tendency people have to hop onto popular trends irrespective of one’s own beliefs. In other words, It’s a form of group thinking where people blindly follow the masses.
Often, we find ourselves sidelining our beliefs and subscribing to other people’s ways of doing things.
We see this with social media trends, fashion trends, political affiliations, and even financial markets. Truth be told, no one loves to be on the losing team. Maybe this is why people are often too willing to align their actions to match those of the winning team. You’ll find investors flocking to specific stocks or mutual funds simply because of what they hear on the news or because the majority of investors are going in the same direction and making profits.
As tempting as it can be, applying the bandwagon effect can be damaging to your net worth. If you really want to be successful, learn how to fight the urge to go with the crowd. Instead, shift your focus on sharpening your own analytical skills and, as a result, making your own sober inferences.
Number 3: Actor-observer Bias
In every situation, there’s going to be two sides of the coin; the actor and the observer. The person executing the action is called the actor, while the observer observes the act.
Actor-observer bias refers to the tendency of being highly critical of other people’s actions, mistakes, or shortcomings. When roles switch, and we’re no longer the observer, you find that this sense of harsh judgment fades.
Naturally, it’s easy to find even the slimmest excuse to forgive your own failures. You’ll rarely ever find people owning up to their weaknesses when they fail. Instead, they’re more likely to blame some wild external factors that are outright beyond their control.
This is why it’s easy to pin someone else’s obesity on a poor diet yet be quick to pull the genetics card to defend your excess weight. Similarly, how often have you honked angrily at another driver who was driving either too fast or too slowly? I’m sure you’ve done it quite a few times but when you find yourself bending the traffic rules for whatever reason, you’ll be quick to conclude that it’s not your fault. This effect also relates to your money. You may be quick to judge someone for a bad investment but when you are the actor making a similar decision, you can rationalize your choice therefore it is often worth getting secondary advice when making financially significant investment choices.
Number 4: The Endowment Effect
The endowment effect is a type of cognitive bias that prompts individuals to over-price their possessions even though the market says otherwise. This particular behavior is typical when dealing with items that bear an emotional significance to individuals.
I’m talking things like jewelry, cars, houses, or even books. When there’s a strong emotional attachment to an object, it creates a false illusion of higher monetary value. This is why you’ll find people overpricing their homes and missing good deals only because they are waiting for a buyer who will accept their ridiculously high price.
Thing is, the longer you take to sell something, no matter how important it is to you, the lower it goes in value. This applies to highly depreciating assets like cars, tech gadgets, and even sometimes stocks. So quit thinking that the objects you own deserve better pricing simply because you own them.
Number 5: The False Consensus Effect
Next, we have the false consensus effect. It refers to the tendency to overestimate the position of our opinions or beliefs in other people’s eyes. It’s tempting to convince yourself that people will always agree with your line of thinking, yet this isn’t particularly true. The false consensus effect stems from individuals holding their opinions in high regard. As a result, they’re trapped into believing that their views are ‘too good to be ignored.’
From a business standpoint, the false consensus effect can be a significant hindrance. I’m sure you’ve encountered a boss that quickly imposes their ideas on their workers. Such business leaders are never open to any form of criticism. As a result, they end up imposing changes that can be damaging to their brands.
When it comes to product innovation, the false consensus effect can hinder a product’s performance in the market. As the creator of a product, you may create a product whose design interface you find easy to navigate. Yet, when you release it to the market, it gives consumers a plethora of challenges. Therefore, it’s important to understand that not everyone holds and same beliefs as ourselves when making business decisions.
Number 6: Hindsight Bias
Have you ever had an ‘I knew it all along’ moment? Turns out, we all do, and it happens more often than you think. If you’re keen enough, you’ll notice that an event’s outcomes become apparent and predictable after the event occurs.
In a nutshell, hindsight bias is a psychological phenomenon that instills a false sense of confidence regarding people’s ability to predict future events. From a psychological standpoint, this kind of bias can make you perceive occurrences to be more predictable than they actually are.
As it relates to your money, you will often feel this bias in effect after you’ve sold a stock. If you sell and the stock soon plummets then you will think to yourself that you are a market at timing the market. The effect may pave the way for over-confidence and if you keep convincing yourself that your predictions are always right, you’ll be more inclined to make wrong moves.
Number 7: Overconfidence Bias
Here’s one that needs no explanation, over-confidence bias. Thing is, as humans, we tend to over-estimate our abilities. This false assessment of our traits and skills makes us prone to making poor decisions. While being confident is a fascinating trait, overdoing it will lead you down the path of failure and disappointment. Overconfidence will make you lock out the ideas of external parties. Yet, in the real sense, their input could have saved your situation.
This is particularly common in the investment and entrepreneurship world. If you believe that you’re always right, you’ll find yourself less cautious when making investment decisions. This causes some investors to risk everything on one single stock, only to end up bankrupt when the company experiences financial ruin.
In reality, exercising caution as you invest will save you lots of money. Doing this doesn’t necessarily mean that you’re less confident. It merely implies that you acknowledge how risky the market can get, and you’re smart enough to tread a little bit more carefully.
Number 8: Survivorship Bias
Moving on, survivorship bias is another cognitive factor that will heavily influence your financial life. To put it simply, it refers to a type of selection bias where data favors the survivors of a given selection process and sidelines the rest of the population that failed to cross over successfully. Actually, this is the most common form of cognitive bias, and we see it every day.
A good example where survivorship bias dominates is in the entrepreneurship world. Often, you’ll hear stories of entrepreneurs that dropped out of school or quit their annoying jobs and still became successful. While such stories motivate, they often sideline the rest of the population that equally ditched their employment and education, yet failed miserably. No one talks about the group of people that don’t survive, which can be misleading. Survivorship bias pushes people to hop onto business trends simply because they know a few people that adopted the trends and succeeded.
Actually, it’s the leading reason why stock market investors make misguided investment moves. Usually, it results in over-hyped historical trends that instill a false sense of optimism in new investors. The result? Money is lost, and lots of it.
Number 9: Confirmation Bias
Truth is, nothing beats the feeling of stumbling on a piece of information that backs up your strongly-held attitudes, beliefs, and opinions. If you’re like most people, you probably believe that you’re the smartest person in the room. It seems, adopting such an ‘ever-right’ mindset makes you susceptible to confirmation bias.
When in action, confirmation bias will lead you to favor information that conforms with your way of thinking and, consequently, proves your smarts.
For example, take someone who holds a firm conviction that poor people are happier than rich people. If this person meets a wealthy person that’s had a bad day and isn’t in a good mood, they’ll jump into the conclusion that indeed, rich people are never happy. If this same person came across a millionaire that’s bubbling with radiance and positivity, they’ll probably dismiss them and argue that it’s sheer pretense. However, such a conclusion is skewed. In reality, we have stinking rich people who are happy and satisfied, in as much as we have poor and miserable people.
As a leader, confirmation bias will hurt your chances of making the right choices. Allowing this form of prejudice to take-over your thought process will only make you plunge your company, job, or investment in a bottomless pit of failure.
Number 10: The Ambiguity Effect
Lastly, the ambiguity effect is another psychological factor that will reflect on your net worth. Simply put, it refers to the tendency of making decisions based on predictable outcomes. When the probability of a desirable outcome is known and visible, people will gravitate towards this direction.
This is why people choose to work with investments that they’re familiar with. If you’ve had prior success with real estate, you’re less likely to put your money in the stock market simply because the probability of success is unknown. Well, it’s only natural to shun choices whose outcomes are uncertain. While this trend is common, it can also lead to poor decision making. Just because you know nothing about a particular venture doesn’t credit its chances of success.