The human brain is an amazing thing. Unfortunately, there are a bunch of logical fallacies that make us act stupid, especially when it comes to managing our money. These fallacies are often exploited and used against us. Ever wonder why prices at stores are never in whole dollar amounts but always end in .99 or .95? That's called odd-even pricing, and it's a dirty little trick that retailers use to make items look cheaper. When most people see the price of $9.99, their brains automatically tell them that the product is not $10, but more in the $9 range. There are many more logical deficiencies in finance, but I'll only cover a few here.
- The Promise of Free
All too often consumers are lead into making purchases they otherwise would not have made, just because something free was included. This explains why so many people sign up for "free" credit cards with no annual fee and a 15% interest rate instead of a credit card with a $50 annual fee and a 10% interest rate. Whenever you see the term 'free,' consider it a warning to slow down and consider your choice very carefully. Do the math and always consider what you are giving up when you choose the item attached to something "free." Usually -- but not always -- there is a real cost to something touted as "free."
Whenever we are introduced into an unfamiliar product category, we're not exactly sure what the items are worth. For example, when a real estate agent shows you two expensive homes and two less expensive ones after that, the last two seem like bargains, but they may still be overpriced. This happens because your brain latches on to the first price it sees and sets the anchor, then all other prices are compared against it. This little mind trick takes away the complicated decision of determining what something is really worth.
- Instant Gratification
People know they need to save for retirement, or that beach trip they want to take next year, but they rarely do. Why is that? Because buying something today is much more satisfying than saving up for future purchases. This is also a huge factor in some peoples' inability to lose weight. They enjoy the instant satisfaction of delicious food rather than the long-term benefits of being healthy and fit. A good way to avoid this mistake is to use the 24-hour rule. When you're about to make a purchase, make yourself wait at least 24 hours and see if you still just have to have it. Also, keep pictures of things you want in the future (new car, vacation) in your wallet and pull it out every time you're about to spend money you should be saving.
Consider this classic economics puzzle. You go to a store to buy a $100 lamp. You then learn that the same lamp is on sale for $50 at another store a mile away. Would you drive one mile to save $50? Now imagine you're considering a dining room set for $5,000. You learn that the identical set is selling for $4,950 at a store one mile away. Do you make the drive? Hopefully you said yes in each situation. However, many people say no, they would not make the effort in the second example. Why? Because 50 percent of $100 ($50) instinctively seems more valuable than 1 percent of $5,000 (also $50).Don't confuse dollars and donuts. Constantly remind yourself that a dollar is a dollar -- just because it's a small percentage doesn't mean it's not still real money. If you're willing to clip coupons to save $10, you should also be willing to find ways to cut $10 off the price of a refrigerator or increase your retirement portfolio's earnings by $10. Or ask yourself: Would I be willing to go to a different store to buy this item if they were handing out $50 bills (or whatever the savings would be)? Picturing your savings in cash makes it seem more worthwhile.
- The Lost Money Fallacy
Once we own something -- a house, an investment stock, a car -- we often irrationally keep it or even put more money into it, even when it's time to walk away. That's exactly why folks are often hesitant to sell losing stocks. Although everyone knows stocks aren't guaranteed, some people irrationally want to hold on to loser stocks 'until they earn their money back.' This can be especially dangerous for people with very few stocks in their portfolio, since they don't have much diversification to begin with. However, while they wait for the stock's price to go up, they could actually lose money on more appropriate investments. Other examples: You continue making expensive repairs to your older car because you don't want to "lose" the repair money you invested in the car last month, three months earlier and six months before that. In today's market, you might also be wary about selling your house for 15 percent less than you bought it, even though you know the sale price is reasonable today. Remind yourself that spent money no longer figures into your financial decisions. It's gone. Would you buy that losing stock today, given its performance, if you didn't already own it? If not, it's time to sell. Next time, establish a stop-loss limit (the price at which you will sell a stock) as soon as you buy it, before you get attached to it. Finally, would you put $1,000 into repairing that beater car if a relative had given it to you for free last week? If not, leave the mechanic's shop -- now. You're trying to financially prop up a sinking ship.