Sunday, February 28, 2010

Six logical fallacies that cost you money everyday

I came across this interesting article of Six Logical Fallacies that Cost You Money Everyday at Cracked.com. It is a light-hearted article that may not be taken seriously. You may or may not agree to its findings, because it is about some of the decisions we make everyday. Naturally, you may think that we are making such decisions logically and correctly. Instead of changing your behaviour right away, these notions are at least worth pondering.

The basic observation is that human beings are evolved from animals. Our brains are adapted subconsciously to living in the wild. Human civilization developed only in the last short ten thousand years. Thus our brains often act on instantaneous responses that do not necessary fit the present day lifestyle, and tell you to do some things that will keep you poor.

Fallacy No. 6 - Think The Future Is an Urban Legend
Natural selection in the wild taught us to take things now, and that the future was less reliable. Rotten meat available now was more valuable than fresh meat to be hunt a week later. Today, the future is more predictable as governed by laws and contracts. However, if a man in nice suit offers to pay you $100 in a year, or $50 right now, our brain will tell us to go for the cash now.

This is called hyperbolic discounting. There are industries that rely on your inability to think rationally about the future. Our whole economic crisis was kicked off by borrowers taking on loans they could not afford, after lenders offered them lower payments, or even no payments, for the first year. Credit card companies still rely on your brain to make purchases now that you will not be able to pay for at the end of the month.

Fallacy No 5 - Sunk Cost Fallacy
We have a brain that worried about making sure we don't waste money we've already spent, or money that's not yours anymore. Say you have been a Mac user and recently bought a $600 wireless Apple keyboard. Now, even though you like everything better about changing to a Dell, with its own wireless keyboard, and it's twice as cheap as the nearest Mac equivalent, your brain will tell you not to waste the money you spent on the keyboard. In the name of not letting the keyboard go to waste, you buy another Mac.

This is known as the sunk cost fallacy: a mechanism in your brain that tells you to spend money on something, simply because you've already spent money on it. In the above scenario, if you were perfectly rational, you would realize that the $600 were gone. The only thing that should figure into any economic decision is the money and possessions you have in the present tense, and how they can be best used to make your life better in the future.

Fallacy No. 4 - Can't Get Rid of Useless Stuff
This is the brain mechanism that tells you to wait for a better price on something that, in reality, will never go up in value. Investors suffer from this all the time; when a stock is losing value, instead of selling it and taking what they can get, they hold onto it. It is not optimism that the stock is going to go up, but rather being reluctant at the idea of selling it for less than they paid.

It's the same impulse that makes people hoard useless stuff, unable to grasp the fact that it'll never be useful again. There is an industry profiting off our malfunction: self storage companies. Your brain is willing to pay $200 a month to store a bunch of useless crap you no longer want or need, instead of just selling it or donating it to charity.

Fallacy No. 3 - Throws Good Money After Bad
We have a brain that loves to compete, and is good at convincing itself that it's right. In the financial realms, when these two instincts collide, your brain will play a game that economists termed "irrational escalation of commitment".

When faced with the prospect of a $3,000 repair on your old car, or purchasing a slightly better used car for $2,500, your brain will tell you to go with the repairs because you "already sunk $10,000 into your old car." But what happens the next time your car needs a repair? Owing to what the behavioral economists termed post-purchase rationalization, your brain will have convinced itself that the last decisions was a great idea. And since you've now sunk $13,000 into the old car, it seems like an even better idea to keep piling up the bad decisions. Throw in a little competitive instinct and pride, and it's not hard to see how this can go horribly wrong.

The real world implications are numerous. It can justify the escalation of a war. In 2005, the US President said that we "owed" the 2,000 American soldiers who had died in Iraq to "finish the task that they gave their lives for." Regardless of what your politics were, to a certain part of your brain, that sounds like a logically constructed argument. It seems that these men have to die because these other men died.

Fallacy No. 2 - Has No Idea What Money's Worth
It turns out your brain is bad at understanding that a $20 and twenty $1 bills are the same thing. That's why entertainment venues make you use tiny denominations: they know you'll spend a lot more. This is called the denomination effect. Scientists conducting an experiment by giving two sets of people either a $5 bill or five $1 bills and watched as the people with the fives held on to them, while the folks with the ones spent comfortably on popcorn and soda. This leads scientists to the depressing conclusion that your brain basically views the amount of money you make as a number, instead of what that money can actually buy.

This is called the money illusion. In reality, your money is only as good as what it can buy. If you have twenty dollars in your wallet, you should be thinking of it in terms of what twenty dollars can buy. Your brain prefers to just stick with the number, and assumes that a higher number means more expensive stuff.

Fallacy No 1 - Sucks at Figuring the Odds
These are the gambler's fallacy and the focusing effect. The gambler's fallacy is the belief that short term actions have an effect on long-term odds. It is a permutation of the focusing effect, also known as anchoring. Your brain has a tendency to latch onto something and never let it go. It served humans well back in the day when we were likely to see both the negative and positive consequences of people's decisions, like good or bad farming practices. But in modern times, we are less likely to see the negative consequences. You hear about someone winning $30 million Mark Six and your brain latches onto that, conveniently forgetting that for the one guy who paid 20 dollars and won $30 million, there are 29 million or so losers who might as well have paid but lost.

1 comment:

  1. These six fallacies may help explain why some people often make stupid decisions. The last example (about American soldiers) used to illustrate fallacy No. 3 is particularly interesting.

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