Optimism Bias May Be Hurting Your Finances: Here’s How
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My grandmother always told me that all I needed was just a dime-size drop of shampoo. In the shower, I would dump a mound on my palm to defy her. I had never been poor.
But, in my 20s, I had my own tough experiences. I let myself get caught in the consumerist wheel of lifestyle inflation and financial insecurity, and then had relationships – one with a boss, the other with a boyfriend – turn abusive. Looking back, I imagine how differently those scenarios might’ve played out if I’d had a few thousand dollars in the bank.
I could not have imagined those experiences until they happened. We humans have what’s called an optimism bias. We think our lives are going to go better than they likely will.
Nothing truly prepares you like an actual experience. Experience changes you.
How Experience Affects Your Mind
Once those events happened to me, the thought of having less than $1,000 saved left me feeling vulnerable.
That’s what’s happening right now as we’re dealing with the Coronavirus pandemic. We are all being changed, and our idea of what we need to feel comfortable is being challenged.
During the first two weeks of the lockdown, my mind was numb, watching a world that before could have only been a Photoshop trick: an empty Times Square, car-free LA freeways, mass graves that could be seen from space.
The world, on pause. No one knew it was possible on this scale. The only thing that truly expands what we think is possible is experience, and we are all having that experience now.
Chances are, you’re not as financially prepared as you’d like to be for this pandemic. I know I’m not. We all know we should save that three- or even six-month emergency fund, but nothing makes that more urgent than the dystopian scene outside our windows.
Imagine how differently this would feel if you had half a year’s worth of rent payments in the bank.
Understanding Your Biases
You can use this experience to make sure you’re more prepared next time, even if next time isn’t a global pandemic, but any of a million other reasons you might need a few extra grand.
Optimism bias is one bias in our brains that’s being studied by the relatively new field of behavioral economics. Not every bias that helped us as cavemen helps us now, but not all of them hurt us, either. There are a few that can help you prepare for the next unimaginable upheaval.
Right now, what you’re experiencing is called salience bias, according to Dr. Vic Matta, Associate Professor at Ohio University’s College of Business.
This is the fact “that individuals are more likely to focus on items or information that are more prominent and ignore those that are less so. This creates a bias in favor of things that are striking and perceptible.”
We see this in the fact that everyone is talking about COVID-19. It’s in our faces right now, reminding us of the importance of having an emergency fund.
The reason we might not have saved one (if we were otherwise financially able to do so), is because of a present bias, also known as hyperbolic discounting, which means that “when most people make decisions, they often prioritize immediate benefits over future gains.”
If you had extra money to save, you might’ve spent it. You might’ve gone on vacation instead of putting the money in a savings account. You might’ve put money toward upgrading your furniture or home-improvement projects that increase the value of your home. Now, you may wish you had stashed your tax refund instead of buying a new laptop.
Instead of assuming everything will work out just as it has, use your present self to nudge your future self into good behavior. One way to do this is to set up automatic transfers into a savings or 401(k) or Roth IRA retirement account.
“I set up a regular deduction of funds from my salary to fund my son’s college education,” said Dr. Matta. “That way I don’t have to repeatedly fend off the bias.”
As time goes on, availability bias will take over. Availability bias is the tendency to use the most recent example as a reason to do something instead of using all the relevant data.
In this case, availability bias may be helpful. If you ask your brain – “Should I save?” It will say, “Yes, remember that pandemic that just happened???”
Dr. Dan Pallesen, a licensed clinical psychologist and a financial advisor, sees this in his work as Chief of Investor Behavior for Keystone Wealth Partners.
“Our older clients still remember living through [The Great Depression and WWII], and you still see the impact in their financial behaviors 70-80 years later,” he said. “Many are still extremely frugal because frugality was a matter of life and death during these difficult times. If you were not smart with the little resources you had, you may not be able to eat.”
Thankfully, the coronavirus will likely be a shorter and less deadly crisis, so the feeling may fade over time.
Using Biases in Your Favor
So what are some ways that you can bottle your panic and use it to create a future in which you’re better prepared?
Live within your means, said Dr. Pallesen. One way to help you do that might be to give yourself a visual reminder to keep the memory available.
Keep a journal of what you’re going through. Write down what you’re worried about and how the financial situation of the quarantine is affecting your life. You may be worried that if you do contract COVID-19, you won’t be able to afford to take time off work.
Then, make a contract with yourself. Write down that you will never again feel the way you do now, adding in specifics. Something like, “I will never again wonder how I will feed my kids if my store shuts down.” Put it in your wallet, hang it on the fridge, or keep it near your laptop.
Remind yourself of how you feel now by changing the name of your bank account to the Pandemic Fund. Do a monthly money check-in with yourself.
Living during a pandemic is often about surviving from one day to the next, but taking steps toward future financial goals is essential as well. Create a system for yourself, and make it much less likely that you ever have to feel this way again in the future. Use the way you’re feeling today to start a system of saving and automate it for when the feeling fades.
You’ll most likely never be exactly the same, just as my grandmother wasn’t after WWII. She saved and stocked up in a way I never did.
“I do think the effects of this pandemic will live on well after COVID-19 is taken care of,” said Dr. Pallesen. “I think people will remember how suddenly things became uncertain and how that felt.”