Why we spend: Are you falling for these costly biases?

Until a few years ago, I used to frequent a store that gave $10 (technically a credit of $10 toward future purchases, but it wasn't cash) back for every $50 purchase. Whenever I got to $40 in purchases, I would add unplanned items to bring the total up to $50 as I couldn't leave the “free” $10 on the table. My rationale was that these items were technically free. But in reality, the rationalization is nonsensical because: (1) The $10 credit was only applicable for purchases made weeks after my original visit and, by the time it became eligible, I had invariably forgotten that I had the credit and so it naturally would expire; and (2) I only needed $40 worth of items, so even though I could get $60 worth of items for $50, I paid $10 more than I intended to and I ended up with $20 worth of stuff that I didn't need. It took me a while to stop this behavior.

We all make money mistakes, and some of us make more than others. But most of time the mistake isn't obvious to us because we also have a lot of biases that prevent us from making rational decisions. Here are some of the biases that cloud our judgment:

1. Status quo bias

In general, people don't like change, especially a change that might result in a loss. We love to do … nothing. So we stick to same old routine, same old insurance or phone company, same investment plan, etc. We continue to do this even when there are better options available because change takes effort.

2. Relativity trap

Also called anchoring, it is one of the popular techniques companies use to make people feel good about the price of an item. It is quite simple and very effective. All the stores have to do is to anchor you to a high price and offer a “discount” to get to the current price — originally $149, now only $79. By seeing the $149 price tag, you are anchored to that price and you feel relieved that you don't have to pay the full price; you feel happy that you are getting such a bargain at almost 50 percent off. At this point, we stop considering whether the item is worth $79, ignoring the original price tag. That is what the store wants us to do, and we fall for it easily.

3. Present bias

In general, we like to live in the present and postpone pain to the future. In a study by Read and van Leeuwen (http://www.ncbi.nlm.nih.gov/pubmed/9831521), when people were asked to choose what they wanted to eat the following week, 74 percent of the participants chose fruits. When asked to make choices for the present week, 70 percent chose chocolate! Why wait when you can get the stuff right away and can worry about paying for it later, right? That is why $0 down mobile contracts and $0 down long car loans are so very popular.

4. Familiarity bias

Advertising works. If we have seen a product many times on TV, billboards, online, etc., we somehow, without meaning to, start thinking it is a better product. We start associating familiarity with popularity and are willing to pay a premium to get the better product even if we know absolutely nothing about the quality of the product.

5. “It's free” bias

One of my favorite biases — and one of the worst to succumb to — is the word “free.” It has a very seductive power over us and makes us do a lot of irrational things. Most of time we end up paying for the free stuff in one way or the other, but we still can't let something that is “free” go. Free-after-rebate items are hugely popular because the rebate redemption rates are super low (ranging from 2 percent to 70 percent, and most commonly about 40 percent). We actually achieve a high from the euphoria of getting a free item and conveninetly forget or mess up the complicated mail-in rebate procedure.

6. Fear of loss

Just about everyone knows about this bias and, at one point or other, has probably experienced loss aversion. We would rather avoid losses than make a profit. Fear of loss is what made millions of people sell their retirement portfolio during the recession and lock in their losses instead of waiting it out. This is also why people overbid on Ebay.

As you might expect, the first step in fixing these mistakes is by acknowledging them. It is difficult, but it can be done. What other biases affect how you spend, and how do you counteract them?

More about...Psychology

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