There are some thinking errors that are so common that virtually all of us make them from time to time. Here are 7 that can put a big dent in your net worth over time.
The Halo Effect
You do something frugal and then use that to justify other spending. For example, you bike to work and then justify buying a frappuccino on the bike ride home.
Focusing on what you’re saving rather than what you’re spending.
For example, you got ‘upsold’ when you bought an internet plan. The company offered a promotional rate on a plan that was faster than you needed. The upgrade was still more expensive than a cheaper plan but you focused on the amount you were saving and not the amount you were spending.
Another example is shopping at discount stores where the original price and the discounted price are marked. On an item that costs $100 for full retail, you focus on the fact you will save $60 rather than that you will spend $40.
The Sunk Costs Bias
For example, you buy a health insurance plan and later realize you bought something more expensive than you need. You keep paying rather than switching because you don't want to make a change until you've gotten value out of your original plan. However, this results in pumping even more money into the expensive plan.
You weigh losses more heavily than gains.
Losing a dollar feels worse than gaining a dollar. This can result in people choosing a suboptimal risk/reward ratio, or panic selling investments when staying the course would be a better option.
Even for people who don’t panic sell when the stock market goes down, you might hold off adding to your investments at just the time when the market is “on sale.”
This general principle of loss aversion also applies to the lengths people will go to pay lower taxes, since taxes are a type of loss. For example, people will sometimes give up positive overall returns because they want to avoid paying taxes on the gains.
Partial blindness to risks: You consider some types of risks but not others.
For example, you think that your money is safe in the bank and perceive that it is not losing value. You consider investment risk but not inflation risk. In effect, whenever there is inflation, you are losing money when you have it in the bank.
You don’t consider opportunity cost.
This is another example of being blind to some types of risks and costs.
For example, let’s say that home prices in your area are high in proportion to rents. You predict that you will still get a small return on buying a home but don’t consider whether you would get a better return through investing in other assets. You don’t consider the opportunity cost of tying up your savings in buying a primary residence.
Calculators like this one can help prompt you to look at the whole picture because of the different questions they ask you to answer.
You don't consider the cummulative effect of small amounts of spending.
For example, check out this analysis of the cost of commuting by car, and the long term impact on your wealth.
Another example is paying what seem like small fees on your investments when lower cost options are available. Free apps like FeeX can help you hunt down these fees.
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Disclaimer: This post should not be construed as investment advice.