5 Mental Money Traps to Avoid for a Solid Financial Future

by David@MoneyNing.com · 10 comments

Imagine that you are shopping for a used car and see a nice one on the lot. After negotiating back and forth with the salesman, you manage to agree on a price that’s several thousand dollars less than the list price. I bet you would sign the title feeling like you got a great deal. Now imagine if the list price was a few thousand dollars lower to begin with, but the salesman refuses to negotiate.

You end up paying the same price, but the feelings you have about the purchase is probably quite a bit different.

This is one of the mental money traps you can fall into.

There are a few more, and this is a long read. So grab some coffee, and let’s get into five of these today and what you can do to avoid the pitfalls.

Mental Money Trap #1: Outsmarting the Anchor-Price Comparison Trap

The used car lot example is called price anchoring. By having a relatively high list price on used cars, customers will remember that price tag and decide whether they got a good deal or not based on that initial price.

The tendency to use the first piece of information we hear or see as our “anchor” for making subsequent spending decisions is called the anchor price comparison trap (some also refer to it as the relativity trap or focalism). This happens most frequently in categories that are new to us, where we have nothing to compare to the prices we encounter.

Whatever you choose to call this behavior, it’s a verifiable bias built into our mental wiring, and it can cost us a lot. The good news is that you can outsmart your own tendency to create pricing anchors with a few simple strategies.

1. Be aware that this trap exists.

The first step to outsmarting this psychological trap is to be aware that we tend to create anchor prices for just about every category of consumption, and they stick hard (like an anchor). Knowing this is how your mind works will make it easier to prepare for situations when you’ll be tempted to compare prices to your mental anchors, regardless of whether they’re accurate. Doubting yourself, in this case, is a good thing!

2. Hesitate before snatching up a “great deal.”

If you’ve felt buyer’s remorse after falling for the anchor price trap one too many times, save yourself some guilt and money by pausing before every purchase, even if it’s a once-in-a-lifetime deal. Quite often, giving the decision some time will reveal new information that sets the “great deal” price in a more realistic context.

It’s especially important to use this strategy with a major purchase like a home since prices and values are established based on the housing market of the individual city or region. A $500,000 home in one area might not be comparable to a similarly-valued house in another area, so shop carefully!

3. Filter the anchor price out. Is it still worth it?

All too often, we see something advertised as 75% or more off the list price and assume it’s a great bargain. In comparison to this anchor price, the sale price seems like an incredible deal. But is it?

A good strategy for determining if a sale price is a good deal is to mentally block out the regular list price. Does it still represent a good deal for the item, for you, and for your budget? This can be hard to do if you’ve already seen the list price but try it anyway. This approach can help you view the price of “great deal” purchases more realistically.

Maybe you no longer fall for the tricks of a sneaky salesman, but do you fall for your own mental money traps? Watch for the anchor price comparison trap and you’ll save yourself both money and regret.

Mental Money Trap #2: Comparing Dollars to Doughnuts

The phrase “dollars to doughnuts” first appeared in the mid-19th century as a catchy way to describe something considered a safe bet. Dollars obviously hold value, whereas doughnuts are essentially worthless (unless you’re a big fan of doughnuts, maybe). So, what does this mean to you, as a consumer, and how can it become a money trap? The answer is best illustrated by setting up an analogy.

Imagine that you’ve had your eye on an item that’s $100, and it’s suddenly being advertised as 50% off. Would you be willing to go out of your way to purchase this item at $50 (and save $50 in the process)? Probably. Pit this against another scenario where you’re considering a more expensive purchase — for instance, a household appliance. Let’s say it retails for $3,000 but it’s marked down to $2,950. Regardless of your budget, would you feel like you got a better deal on the $100 item marked down to $50 versus the $3,000 item marked down to $2,950? Probably.

The reality is that both these deals represent a savings of $50, but the first is a saving of 50% while the second is a saving of something like 1%. If you’re like most people, it feels like saving 50% off is way better than saving 1%, regardless of the dollar amount.

That’s why on bigger purchases, a relatively small amount of saving can sometimes feel like it’s not worth the effort. If you’re willing to spend a little extra time to save $10 on groceries, shouldn’t you be willing to make the effort of saving $10 on your utility bill or investing $10 more into your retirement account?

Remember: A Dollar is a Dollar, No Matter How Small

A dollar is a dollar, wherever it shows up in your budget. Saving a dollar of interest on your loan payment is just as impactful as saving a dollar on your grocery bill. This is especially important to keep in mind with areas of your finances that aren’t in front of your eyes or in your pocket.

Side Note: I used to feel bad when I ask for a discount on a seemingly small item, but not anymore. Nowadays, I overcome my fear of the other person looking at me funny by imagining to ask him to give me that savings out of his own pocket. After all, it’s not rational for someone to think a savings is negligible if he isn’t willing to just give me cash from his own wallet.

Picture Your Savings as Cash in Your Pocket

Another reason it’s easier to feel like we saved more on one purchase over another or a bill, loan, or investment is that we don’t picture them in terms of cash value. A common suggestion is to imagine that someone a few blocks down is handing out $50 bills with no strings attached. Would you be willing to drive a few miles for it? Of course! $50 in cash is tangible; it’s money in your pocket. Think this same way about every dollar you save in other areas of your budget, your mortgage, or your retirement savings, and you’ll be less likely to limit your ability to save money and get ahead.

A confession: I am guilty of this money trap. I’ve walked to different parts of the shopping center just to comparison shop $3 worth of Tylenol, but I can be impatient and make hasty deals on a car that can mean potentially losing out on hundreds of dollars. One way I’ve found that helps me combat this is to not rush into a buying decision, as having a bit of time to think about the savings can make all the difference.

Mental Money Trap #3: The Sunk Cost Fallacy

Have you ever sat through a bad movie just because you didn’t want to “waste” the money you spent on the ticket? What about a dud of a car you refused to give up on despite multiple trips to the mechanic? If so, you’re not alone. This behavior is a mental money trap economists and psychologists call the sunk cost fallacy or the escalation of commitment, and it can cost us money, time and unnecessary emotional stress.

Why do we so often stubbornly refuse to count our losses and move on? Let’s expound a little on what the sunk cost fallacy looks like.

Most of us have an instinctual aversion to loss. In many situations, the prospect of losing money becomes more powerful than any other reasoning — even the possibility of coming out ahead. This is easily illustrated by gambling habits. Based on behavioral studies, most people refuse to bet on anything if the promised payoff is less than double their investment.

On the flip side, this might also be why we have an affinity for free deals or gimmicks. We’re more than willing to take something that’s free, even if it’s not anything we need or even like.

Secondly, the more we invest in something, the harder it is to take what we believe to be a loss on it. It’s strange to think that we can get emotionally attached to objects, but it’s true. Investing money into something comes to signify more to us than just cash – it’s our time and our labor.

Sitting through a movie you don’t like just because you paid for it is a light-hearted example, but this fallacy hits harder when it affects larger things like stocks or real estate. Some people find it hard to part with a poorly-performing investment, waiting and foolishly holding out for the stock to perform better when all the signs say to sell it and reinvest somewhere else.

Trying to get the maximum return on any investment is wise, but propping up a “sinking ship” isn’t.

Others might have a hard time selling their home for less than they paid for it years ago, even if they can fetch a solid price based on today’s market prices. Unless you have fact-based reasons to believe the housing market will improve, holding out to sell could mean getting even less than your home’s value if, instead, the market takes a dive.

To combat the sunk cost fallacy, keep the following things in mind.

1. Remember that, in many cases, money spent in the past no longer factors into making the wisest financial decision in the present.

Would you still buy that stock today, with its current performance?

Without factoring in what you paid or the money you sunk into it, would you feel like you were getting a good deal if you bought your home today, at its market value?

What is your car’s current value, today, regardless of what you bought the vehicle for? If someone had given it to you for free, would you still pour money into the ride?

2. Use the concept of a stop-loss order to cut emotions out of your decisions.

In the stock market world, a stop-loss order sets the price at which a broker is supposed to sell a holding if the market takes a turn for the worse (there’s much more to it, but that’s the overall idea). It’s a proactive way to avoid losses with less active management of your stocks, but you can apply the concept to anything you invest money in. Set a limit at which you’ll stop pouring money into a lost cause – be it a stock, a car, or something else. This will help you make decisions based more on numbers versus feelings.

A word of caution: Be careful with setting automatic stop loss orders on stocks within your stock broker platform. Since stock values are volatile, you can get stopped out, realize the stocks you own were all sold, and see that the price has already bounced back if you don’t know what you are doing. It’s good to have a mental stop loss for any investment, but you really need to know what’s going on to use the automated trading tools every broker seems to have now.

Don’t let the sunk cost fallacy mindset get the best of you. Asking these questions can help you get past the hang-up of “lost” money that’s in the past and keep you from hesitating to make the best financial decisions for today.

Mental Money Trap #4: Mental Accounting

Whenever I receive an unexpected lump of cash such as a gift card, bonus, or tax refund, I find myself extremely tempted to treat it differently than other income.

Instead of looking at the budget to see where it might best benefit our overall financial situation, I immediately think of what “extra” thing I could spend it on since, well, it’s “extra” income, right? The bills will still get paid and the budget won’t suffer, regardless of what I do with the money.

I’m not alone in this mentality. Apparently, it’s something financial behavioral psychologists call mental accounting. Basically, this means we tend to assign different values to different money sources based on how much effort we put into earning them. Income that’s gifted doesn’t seem like our money, somehow, so we treat it differently, whether more cautiously or more frivolously.

The first tendency, as I started with, is the impulse to spend it. It’s easier to treat extra money with less discretion than we do our hard-earned payroll check. A 2009 study done by Harvard researchers illustrates this point. Participants in one study group were given $10 more per person than those in the other group and told this was “extra” money; consequently, they spent 20% more than the other group.

Although there’s nothing wrong with spending a little of your bonus or settlement money on something you want, extra money can tempt you to make poor decisions, especially when the amount is significant. For instance, you might rationalize using an extra lump of money for a down payment on a fancy car you otherwise wouldn’t be able to afford. This adds a monthly payment and thereby affects your budget, and, sometimes, even your lifestyle expectations.

This is the first way we tend to treat extra money, but there’s another scenario: treating certain sources of income as “sacred.” It might be inheritance money, a gift from a relative, or retirement funds you’ve saved up. Some people are afraid to use “sacred” funds for normal budget purposes or slightly riskier investments, so this money is guarded in safer places. The downfall of this behavior is missing out on maximizing your earning potential with higher-yielding investments. Less risky stocks or basic savings accounts may protect this extra money, but it won’t necessarily grow.

So, what’s the solution to these two pitfalls of mental accounting? The key is to change the way you think about income, whether earned or gifted. Think of all the money you receive as your money, and all your money as equal. Regardless of where it comes from, all money is the same, so use it as you would if it all came from the same source.

In a practical sense, this means looking at your debt, your budget, your retirement plans, and your savings categories and deciding where “extra money” income will best serve your overall financial health. This might mean paying off some high-interest debt, increasing your retirement savings, or investing in a higher-yielding fund or savings goal.

Don’t let mental accounting lead you to treat extra money any differently than the income that it is. Use it wisely and you’ll yield financial rewards that keep on giving.

Mental Money Trap #5: Falling for Bundles

Let’s face it: we love bundle deals, whether it’s a combo meal at a restaurant or bundling services together like Internet, cable and cell service. Marketers know it, too, which is why bundle deals are very common in every aspect of consumerism. While bundles make us feel like we’re getting a special value (as sometimes they are), they can also be money pitfalls that lead us to spend more money than we intend on things we neither need nor want.

One of the key reasons we love bundles besides feeling like it’s a better value is the convenience. Standing in line at a fast food restaurant, staring at the menu board and trying to make a fast decision about which separate items we want and wondering what the total will be, we spot the bundled “value deal” with its clear price and the shortcut immediately gives us mental relief.

Bundles save us from this ambiguity effect – a cognitive bias in which our ability to make a decision is hindered by a lack of information (in this case, how much money each separate item costs and what they total). A “one and done” decision is mentally easier for us, so we gravitate towards it.

Marketers exploit this tendency to get us to buy items we wouldn’t otherwise. For instance, some studies show that fast-food customers are more likely to purchase fries if they’re available in a meal bundle than if they’re only available a-la-carte. By bundling, retailers and marketers can increase their sales, clear out slow-moving inventory, or boost a poor seller. Landline services with Internet bundles anyone?

And speaking of fries, I always skip the fries when I go to In-n-Out, a burger chain that simply adds the price of a medium size drink, fries, and the burger into the meal price with no discount. On more than one occasion, the cashier would give me a slightly funny look just because I didn’t want fries nor the sugary drink and wanted to eat in.

I really just want the burger and skip the others mainly for health reasons, but it’s another obstacle for people trying to break away from the norm. My reward is a fatter wallet and slimmer gut though, so I can’t complain too much.

Do Bundles Save You Money?

Now that we know why we fall for them, let’s look at whether they represent the value they claim. The answer is: not usually. If there is a discount, it’s usually less than 5% (not that you shouldn’t consider small savings worthwhile – remember the dollars to doughnuts analogy?).

In most cases, you’re paying just as much for items that are bundled as you’d pay for them individually. Retailers can get away with this because they know you’ll automatically think you’re getting a better deal and won’t usually bother to do the math.

The Real Value of Bundles is Convenience

As I mentioned earlier, we like bundles because of their convenience. We’re often willing to pay a little extra for convenience because convenience is time, time is money, and the pursuit of the things we want to be doing is more important to us than a few extra cents or dollars.

The important thing is understanding that this is the real value of bundles – not saving money.

Be Wary of Bundles That Cost You More in Money and Clutter

If you’re not taking advantage of a bundle for its convenience, consider whether you’d still buy each of the bundled items separately. Is there something in the bundle you don’t need or want, but figure it’s just part of the deal? The reality is that you’re paying (probably full price) for something you don’t need or even want. In many cases, it’s better to skip the bundle and purchase only the items you need.

Not only will you save money by taking a double look at bundles; in the case of consumables, you’ll save yourself extra calories or wasted resources. In the case of merchandise, you’ll save the need to transport everything back home just to clutter up your home.

Bundles are fun and convenient, but they only represent savings some of the time. If you’re up for that, at least understand the trade-off. More importantly, be wary of falling for bundles under the guise of getting a good deal. If it’s costing you more than you’d be spending otherwise, surprise the marketers by passing on their conveniently-packaged “value.”

Knowing is Half the Battle

We can attempt to apply all the money tips that are out there, but we are shooting ourselves in the foot if we keep falling into mental money traps that cost us money. Winning the personal finance game is as much about mindset than it is about knowing specific ways to save.

How many of these traps do you fall into? Will you make an effort to identify and avoid the pitfalls from now on?

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{ read the comments below or add one }

  • Carol says:

    So true! Very educative. Thanks for sharing. I learnt a lot reading this.

  • Beau W says:

    I was amazed at the Harvard study. I think we’re all guilty of money mental mistakes. I know I am. I’m definitely going too remember this post. Good points sir.

    • David @ MoneyNing.com says:

      I was surprised at the 20%, but I remember how the sellers of my house told me they spent quite a bit of money when he first got a huge windfall through his company’s IPO. It all makes sense. It’s hard to not spend it when you all of a sudden feel much richer.

      Good for him to be at the right place at the right time, but he would probably be way wealthier if he kept that money.

  • Joe on the Move says:

    You were kidding about this being a long read.

    Sadly all of these apply to me, so perhaps I needed the time today to tackle this article!

  • Stay at Home Mama says:

    Oh I struggle with the one about thinking savings are the same whether it’s for a $500 purchase or a $3000 purchase.

    From now on, I need to realize that $50 is the same savings no matter how much something costs. I bet it’s easier to save $50 on a large purchase than a small one anyway!!

    • David @ MoneyNing.com says:

      You are so right. It’s much easier to save $50 on a large purchase than a small one. But why stop there? Aim for a $500, or even $5,000 discount on big purchases!

  • Nikki says:

    I always cringe whenever someone tells me they still own a landline, but I guess it’s because they bought it with a bundle of Internet and/or TV service.

    I wonder how much money our country is wasting on phone lines that never get used? I guess companies like AT&T are racking it in but it can’t be good for our country’s finances, especially when over 30m people are unemployed.

    • David @ MoneyNing.com says:

      That total WOULD be interesting!

      It would be interesting to see how much just that subgroup of 30m people pay for stuff they can easily cut back too.

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