Unconscious thinking patterns are influencing our perspective and steering our actions even when we believe we’re making conscious, logical decisions. I sometimes find myself making self-sabotaging decisions and wondering whether something else is at play — what made me do that?!
The tendency to develop habits isn’t all bad. Habits provide structure and familiarity to our day and give our minds one less thing to think about. Being creatures of habit can also be downright good for us. After months of repetition, it’s the force of habit that gets us out of bed to work out, make healthier food choices, balance our budget at the end of the month, or set aside money in savings.
But it can also be bad. Kicking a bad habit — be it a personal, social, emotional, or financial — can be extremely difficult, especially the longer that habit has been in place. This is especially true if it’s rooted in a skewed thinking pattern. Habits of thinking spill over into the way we act and have both positive and negative implications for the way we handle our finances.
Previously, I’ve talked about some of the common money traps and money mindsets that can sabotage your best financial intentions, and I recently came across another one. It’s known as the recency effect (or bias).
What is The Recency Bias?
The recency bias is rooted in behavioral psychology. The serial-position effect, introduced by German psychologist Hermann Ebbinghaus, says that when people are asked to recall a list of items from memory, they tend to start with items that were listed most recently (the recency effect).
It works the same way with our memory of past experiences — we tend to emphasize the most recent data and use it as a baseline for how things will continue to happen in the future. Unfortunately, this recency bias leads us to make decisions based on the assumption that things will continue as they have, indefinitely.
How This Bias Affects Our Finances
Enter money decisions.
Just because things have been going well for us, financially, doesn’t mean they will continue to forever. We know this, yet we tend to make financial decisions (or fail to make them) based on the unconscious assumption that things will continue to go our way. In the financial world, you’ll see the recency bias applied mostly to investing and stock market activities (it’s also called the party effect), but it can apply to any area of finance.
In the investment world, the recency bias causes people to evaluate their portfolios based on recent performance and assume that the market (or company, or stock) will continue to stay the same. For example, if there’s a long-term bull market, investors might get a little too comfortable or risky. It also works the opposite way: if there’s a long recession, it can take a while for investors to trust the market, even if there are strong signs that it’s on the upswing. Analysts cite the 2008-2009 recession as a prime example of both these reactions.
The recency bias can also affect the way we plan for unexpected expenses or loss of income. If we haven’t repaired or replaced anything in the last six months or made a trip to the emergency room in a long time, it’s easy to justify not setting aside as much into an emergency fund, re-allocating funds, or even waiting to start one. If you’re a contract worker with long-term clients, it’s easy to assume they’ll continue to provide a steady stream of income and fail to line up new leads.
Tips for Beating the Recency Bias
Even though this is a mental trap we’ll always struggle against, there are ways to outsmart and work around it.
1. When making financial decisions, consider all possibilities and potential outcomes.
Look at the big picture and consider the long-term track record of the category. When investing, assess your risk tolerance, form a solid long-term plan (maybe with the help of a professional) that accounts for all the ups and downs of the market, and don’t get distracted by short-term trends. In other areas, this might mean stepping back to assess your finances and look for patterns over six months, a year, or more.
2. Plan for the unexpected.
It doesn’t cost much to be prepared, even if the worst doesn’t happen. Having that tire repair kit or emergency-stranding kit in the trunk for years without using it (be sure to check its functionality from time to time!) is better than not being prepared the one time you need it.
When planning your budget, round up categories to leave some wiggle room for fluctuations, and continue to set aside money in an emergency fund for short-term expenses and longer-term situations such as a layoff. If you use these funds, replace them without hesitation.
3. Recruit a second set of eyes.
Because we’re limited by our personal perspectives, it’s always a good idea to seek out an objective family member, friend, or financial advisor to offer a different one. Someone who’s not in the thick of it all can better assess our situation and spot areas where we’ve unconsciously fallen for this bias. We’re all in this together, so let’s help one another out.
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Always have a willing mind to learn something new at any age, stay humble, and most importantly, stay frugal. It’s ok to splurge once in a blue moon, but frugal down when necessary so you play your $ gUaP $ cards correctly and have money in your golden years for retirement.
Nice rundown on this concept – and even citing research! This is something I always struggle with – am I letting this bias impact decision? The techniques for calling it out help.
When talking to people who are just starting investing, I see them sort funds by “12 month return” and choose the top one over and over (in our 401k). Too bad there’s no sort order for FI rating.
If you get into affiliate marketing and blogging, you’ll find yourself making way more $ gUaP $ than investing. And stable, good money too. 🙂