Have you ever wondered why your budget looks good on paper but doesn’t work well in real life? If so, then you are not alone.
Interestingly, the latest report from the Office for Statistics Regulation revealed that 40% of participants used official statistics to inform personal choices, such as budgeting, in the last month. This illustrates the significance of data; and our biases in interpreting it in our financial decisions.
Most people do not spend too much because they are careless. They do this because their minds are quietly working against them.
Cognitive biases are mental shortcuts that help us make quick decisions, but they do not always lead to good decisions. When it comes to finances, these biases can fully disrupt our budgeting goals.
The good news is that once you recognise these biases, you can work around them effectively. You don’t need to be a finance expert to make better decisions. A little bit of awareness can boost your decision-making skills.
At Circadian Capital, we help you manage personal biases by creating financial plans tailored to your habits.
Let’s explore the five common mental traps that may be hurting your budget, along with tips to help you spot them. Keep reading.
Cognitive Biases That Hurt Your Budget
Here are the five cognitive biases that hurt your budget:
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Present Bias
Present bias makes us choose quick rewards over waiting for larger benefits later. This explains why you might buy new sneakers when you should be saving for a weekend getaway or why it is easier to order takeaways instead of cooking at home.
This bias isn’t about a lack of willpower. It is about how our brains naturally lean towards immediate rewards. The problem is that your future self doesn’t get a say in the present, and you might end up facing consequences later.
Surprisingly, recent data from Barclays found that around 37% of adults reported trying to reduce their spending to prepare for higher household costs. This change resulted in a 2.9% decrease in essential expenditures, which is larger than 1.0% reduction a couple of months ago.
Instead of completely resisting these impulses, try to align your fast decisions with your long-term goals. For example, if you are saving for a vacation, keep a picture of your dream destination on your phone to remind you of your goal. This simple reminder can help you focus more on saving.
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Sunk Cost Fallacy
The sunk cost fallacy makes us stick with something simply because we have already invested money in it. For example, think about that gym membership you never used or the subscription you forgot to cancel. We often keep these plans because stopping feels like wasting the money we have already paid.
But here’s the truth: spending more money because you have already spent some can lead to a messy budget. You won’t get that past money back, no matter what.
Permit yourself to go. Imagine starting fresh. If you could make a new choice, would you sign up again? If the answer is yes, it might be time to cancel.
If you want to know more about how the sunk cost fallacy influences our decisions, we advise you to read the article: How the sunk cost fallacy influences our decisions.
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Optimism Bias
The optimism bias leads us to think that the future will be easier. We often tell ourselves things like, “Next month, I will spend less”, or “I’ll start budgeting once the holidays are over.” It feels good to believe that our future self will have more willpower, more money, or more time.
However, our future shelves mostly continue to maintain the same habits, expenditures, and distractions. We keep putting off our plan to “improve later.”
A better approach is to focus on what is true in the present. If you are struggling to save money with your current lifestyle, no budget will solve that problem. Instead, try setting up a small automatic savings right after payday.
Make that decision once, and let it happen automatically.
If you’re curious about how optimism bias can impact construction projects, take a look at this article: A Simple Chart to Identify Optimism Bias in Your Construction Projects.
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Anchoring
Anchoring happens when we focus on the first number we see and use it as a standard, even if it is random.
Ever seen a sale and thought, “This is a great deal” just because it is fifty percent off? The original price served as the anchor and impacted your decision.
We also do this with budgets. If you spent £300 on groceries the previous month, you might automatically set that as your budget again without checking if it fits your actual needs.
It’s essential to question this habit: Is this helpful figure, or is it just familiar? Do I need to spend this much, or am I just copying last month’s spending?
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Loss Aversion
Loss aversion makes us feel losses more strongly than we feel gains. This can affect how we budget. You may even keep spending money on something just to avoid the discomfort of stopping, even if it no longer helps you.
For example, if you signed up for an expensive meal delivery service, ending it may feel like a loss. But if it no longer adds real value to your life, holding on to it isn’t helpful.
Think about your decision again. Focus on what you will gain instead of what you will lose. You will have more space in your budget, less stress, and maybe enjoy a lovely evening out that you truly value.
In fact, a recent figure has shown that 82% of UK consumers displayed loss aversion, placing greater priority on losses compared to equivalent gains, with an average loss aversion co-efficient of 2.12.
Awareness Builds Better Habits
Comprehending how your mind works does not mean you have to make every spending choice. It means you can make decisions with clear awareness.
Budgeting becomes easier when you view it as something you do for yourself and not against yourself. The first step is to identify your patterns.
Conclusion
Cognitive biases are not personal failures; they are part of how we think. However, they can lead us to make poor financial decisions if we are not careful.
The good news is that you don’t have to outsmart yourself. You need to recognise these traps and find ways to avoid them through small actions. Take a moment to halt before making impulse buys and set realistic goals that match with who you are. Change can start small.
If your budget seems off next time, don’t blame yourself; it’s a common issue. Instead, look at the ideas behind the numbers. Just being aware of this is a crucial step ahead.