Note: This is a guest post from David Rodwell.
Everyone makes errors in judgment. And, it’s more than likely that everyone makes errors in financial judgment, too. Consumers tend to avoid assessing these errors. Maybe they’re painful or maybe they think they just won’t make them again. Perhaps they feel that no good can come of dwelling on past mistakes. But in the case of financial judgments and understanding, it’s incredibly important to recognize errors. Why? Because increasing awareness can not only prevent future mistakes, but can lead to an all-around financial and personal understanding.
Errors in financial judgment happen no matter what your age, education, or financial background. After all, the mind sifts through hundreds and hundreds of beliefs, cognitive plans, and estimates before making a decision. It’s only reasonable to accept – and expect – that errors can occur. When it comes to financial judgment however, errors are something most consumers strive to avoid.
Where do errors originate?
Some of the most common errors in financial judgment are based on cognitive biases, which is a pattern of behavior that can distort judgment.
One such consumer behavior is our aversion to loss. This one is so strong that we tell ourselves we have control over our own behavior when we do not. Another is the bandwagon effect. That’s a group dynamic about an option that we tend to join because of the power of the group. And, another biased consumer behavior is a choice supportive bias: we tell ourselves our choices were actually better than they were in reality. Exaggerated expectations, as well as thinking in terms of future probabilities being controlled by events in the past, called the gambler’s fallacy, also affects consumer financial judgments, and not for the best.
Consumers tend to act in terms of self-fulfilling prophecy as well. This means that we’ll use thought patterns that are confirmed by existing ideas. For example, if we believe that hard work will equal financial success, we’ll keep going, no matter how hard the job. It also means that if you limit your belief in your success or prevent yourself from trying something new or buying something different, you’ll perpetuate negativity, and keep yourself from making that great investment, or using that new computer.
Consumers can have a strong self interest in feeling that they are both competent and in control. While this can lend to increased confidence and competence, it can also lead us to think we have the ability to control random events – such as stock market fluctuations.
Consumers also often fall prey to predictable shortcuts when processing financial information. They may rely on what a salesman says is the bottom line on a car price when negotiating. They may minimize the length of a loan term to make a loan seem more affordable and reasonable if it’s something they really want to purchase.
In addition, consumers may experience the so-called planning fallacy, thinking about how long a task – or a financial term – will take but neglecting to consider interest fees, depreciation, and actual cost to benefit.
Consumers may also be faced with a reactance bias, resisting or rebelling against a logical choice because it is something that limits their freedom. It’s this type of bias that leads people to insist they can afford an item they really can’t, or that they can survive an employment layoff without any downsizing of personal spending.
Other financial errors in judgment can be caused by the peer pressure inherent in the herd mentality that leads consumers to behave in a particular fashion, or spend in a particular fashion because everyone else is doing it. Wishful thinking and an escalation of commitment to a resource or product or financial action that doesn’t yield a desirable return also lead to errors in financial judgment.
Recognizing these common errors in judgment teaches consumers to avoid them and instead base financial decisions that are in logical evaluation rather than in the judgment biases that can be a part of our daily life.
David Rodwell is a seasoned writer in business and personal finance, taking a particular interest in payment processing. You can find more of his articles located at CreditCardProcessing.net.