When It Comes to Money, Your Brain Can Be Your Own Worst Enemy

With the average credit card interest rate at nearly 24 percent, according to LendingTree, it’s expensive to stay in debt. Yet 29 percent of credit card customers pay only the minimum or close to it, even when they can afford to pay more, according to data from the National Bureau of Economic Research. It doesn’t make mathematical sense, but one explanation for this tendency, experts say, is a form of cognitive bias called anchoring. A term borrowed from behavioral economics, the anchoring effect describes our tendency to over-rely on a piece of information presented to us. For example, when a credit card statement suggests a minimum payment of $25, that amount becomes an anchor, guiding people on how much to pay each month.

We like to think that good financial habits are simple — crunch some numbers, create a budget and stick to it. But if being good with money were that easy, we’d all be good with money. Many of our financial struggles have more to do with psychology and behavior. And several kinds of cognitive biases can keep us from making smart financial moves.

The Here and Now

If present bias could be summed up in a single word, that word might be “YOLO.” This bias describes our tendency to overvalue the present, often at the expense of the future. Research, including a study from the University of Rhode Island published in 2019, suggests that present bias poses significant challenges to saving money. Unsurprisingly, it often leads to overspending.

An awareness of the bias might help counteract it, said James Choi, a professor of finance at the Yale School of Management. In a study on early-withdrawal penalties, Dr. Choi and his colleagues tested this idea. They gave people money that they could deposit in two different accounts. One allowed them to withdraw the money whenever they wanted. The other, which the researchers called a “commitment account,” came with early-withdrawal penalties of either 10 or 20 percent. In some cases, participants couldn’t withdraw the money early at all.

Dr. Choi and his team found that when both accounts paid the same interest rate, people deposited more money into the commitment account. In other words, ‌people might have known that their future selves would be tempted to take out the money, so they chose the account that would penalize them for doing so.

Article source: https://www.nytimes.com/2023/02/26/business/personal-finance-cognitive-bias-retirement.html