You crack open an eye to sunshine on your face and a gentle breeze whispering through the window. The day unfolds, promising perfect temperatures. You head straight to your favourite coffee shop across the street. And as you enter, you smell the aroma of freshly brewed coffee. Soon, a steaming cup warms your hands. As you sip, you pull out your phone and watch a YouTube video. A fervent YouTuber explains with numbers why you will never be rich if you keep buying coffee. Immediately, your colourful coffee shop scene becomes a sad scene of a black-and-white movie. You sink into the feeling of self-doubt and start questioning your decisions.
But Are we making a major financial mistake by buying that cup of coffee? Finances can feel under control; We may have a proper checklist of budgets and savings goals. But we fail to recognise how emotions drive our financial decisions. No matter how many numbers we run in our minds, we will fail to point out the mistakes we commit. The Different Concepts of “Behavioural finance” explains biases that affect our financial behaviours. These theories are crucial to help us be more mindful in our decision-making. They can make your coffee shop scene colourful again while rejecting annoying YouTubers. Let’s do that with the research of Nobel-winning economist Richard Thaler.
The Endowment Effect: The Secret Bias.
The endowment effect makes us overvalue things we own. Once we own something, we often believe it’s worth more than it actually is. And the same stuff will be worth less if it belongs to somebody else. This Cognitive bias can cloud our judgment when buying, selling, or deciding what to keep. We tend to do this because we develop a sense of attachment to the things we own. We can comprehend this concept through an example. Richard Thaler did a famous Mug experiment.
Participants were divided into two groups:
Group A: Received a mug for free.
Group B: Did not receive a mug.
Both groups were then asked to state a price for the mug:
People in Group A (who owned the mug) valued it much higher than those in Group B (who didn’t own it).
People in Group A inflated the price of a mug due to their attachment, which resulted in developing a bias. People think they are making rational choices, but they often fall victim to the endowment effect.
For example, Brands and advertisers use the endowment effect to their advantage. They would initially offer free trials or drastically discounted prices to attract customers. They do this to make the customer develop a sense of attachment to the product.
The Rookie Gambler.
We tend to experience the pain of losing significantly more than the pleasure of gaining. The psychological impact of losing $20 is greater than the pleasure of finding $20. People tend to feel stronger negative emotions from losses than from gains. Loss Aversion bias induces irrational decision-making, which majorly impacts our financial decisions.
The Tale of Infamous Casino:
You walk into a casino and encounter two different gambling options.
Scenario A: The Winning Gamble
You start with a $20 win. Now, you have the option to flip a coin:
If you win the flip, you receive an additional $40.
If you lose the flip, you walk away with nothing.
In this situation, many people choose not to take the risk of the coin flip. They preferred to keep their $20 win rather than potentially losing it all.
Scenario B: The Losing Gamble
You start with a $20 loss. Now, you have the option to flip a coin:
If you win the flip, you get your $20 back.
If you lose the flip, you owe an additional $40.
In this case, people are often more inclined to take the risk of the coin flip. Loss makes people more eager to take risks to recover the money they’ve lost, even if it means risking more.
People make these mistakes in real-world scenarios while holding on to the loss-making stocks. The fear of realising the loss is so intense that it overrides the rational decision to sell the stock and cut its losses. This behaviour can lead to significant financial losses.
You think you are a rational decision-maker. Think again.
Mental accounting is a behavior bias that explains how people think about money. How they treat their money or how they categorize their money. The mistakes we commit while dealing with these questions lead to irrational spending. One of the most common traps of this bias is when people make mistakes while budgeting. Suppose we budget our monthly expenses and create categories for our major expenses. We allot the money for each expense in an envelope. Although it is a good habit to have a budget for expenses, we are more likely to become rigid when dealing with them. We fail to adapt ourselves to changing income or expenses. Let us comprehend this with an example.
Imagine you find $500 on the street. How are you going to spend it? There is a high chance that you will splurge on something you have been wishing for a long time. Perhaps an expensive dinner or an expensive bottle of liquor. You are doing this because you are treating $500 as free money. Now, you have several household expenses. You have the opportunity to compensate for the expenses with the $500 you found on the street. There is a high chance you will ignore compensating your expenses. Because you have already made a “household expenses” envelope in your mind, you will think you have already contributed to your monthly quota of expenses. And you have earned the liberty to shell out $500 for something lavish. We may not have foolishly splurged the money if we earned that $500. Here, we are trying to treat money differently based on how we got that money. The value of $500 remains $500 no matter where it comes from.
Richard Thaler conducted a study. When fuel prices dropped during the 2008 mortgage crisis, people started treating it as “found money ” instead of saving the extra money. The fuel prices dropped from $4 per gallon to $2. So, if a family spends $400 for fuel per month, they would save roughly $200. It would have been a massive relief for middle-income families. Surprisingly, people started spending on premium fuel because they had made a mental budget for the fuel.
Corporations like Starbucks exploit this bias by issuing reward cards to customers. Suppose you load $50 on your Starbucks card. It will be your coffee budget by default, and you can’t change that.
We need to challenge mental accounting bias by questioning why we allocate money to specific categories. Are these decisions based on logic or emotion? We must be open to reallocating funds based on changing needs and priorities.
“Don’t cry over spilled milk.” The sunk cost fallacy.
Money is sunk when it has been spent and cannot be recovered. This lost money is known as a sunk cost. Although this fallacy is an economic principle, it is not limited to money. It can also be applied to time, effort, etc.
Suppose you go to a movie and pay for the premium VIP seats, but the movie is unbearable to watch. Will you leave the theatre? Or will you continue to watch the movie? Most people will go through the torturing experience to complete that movie. They want to recover the worth of the price they paid. Now, if we twist the above scenario, say you got those VIP tickets for free. You will most likely leave the movie theatre because you paid nothing for it.
This bias pushes us to experience more pain, even after we realise that the money we have spent is not coming back. Thinking with a slightly different perspective can help us make better decisions.
The Key
We can try to avoid all the cognitive biases by being extra mindful of ourselves. For example, we can discuss our confusion with a neutral friend and reassess our decision. We can also write down the reasons for our actions and explore the validity of our decision. It is difficult for us to ignore our emotions, as they have a strong impact on our decisions. We need to fight that out. Being mindful and aware is the key.