We’d like to believe we’re all rational, logical, and well-thought-out human beings.
Well, that’s a hard no!
For today’s post, since we enjoy reading about and learning more about psychology including personal finance behaviour and biases, we thought we’d list and describe how to be mindful of these personal finance biases. These biases will influence your judgments, beliefs, and decisions when it comes to money management.
It’s not wrong, it’s just stuff to consider! Yours truly included!
What is a Cognitive Bias?
A cognitive bias can be described as a systematic error in thinking that occurs when people are processing and interpreting information in the world around them and that impacts the decisions and judgments that they make.
Baises are not wrong or bad unto themselves since while the brain is extremely powerful, the brain is also very limited. We can only process so much information for a given circumstance.
Biases often work as rules of thumb – like the 4% rule – to help us make sense of an increasingly complex world. Biases also help us with our attention span, or at least maintain our wits. At best, including these days, people are only somewhat paying attention! Since an attention span is a limited resource, people have to be selective about what they pay attention to.
So, biases are part of our DNA. They can and will creep in, to influence the way we live and what we make decisions on. Big or small.
The concept of cognitive bias was first introduced by researchers Amos Tversky and Daniel Kahneman in 1972. Since then, researchers have described a number of different types of biases that affect decision-making in a wide range of areas including social behavior, cognition, behavioral economics, education, management, healthcare, business, and finance.
Sometimes, our biases (we all have them!) are obvious. Some others are more subtle.
Check out our list below for some personal finance biases to be mindful of.
Be Mindful of these Personal Finance Biases
1. Confirmation Bias
This bias includes the tendency to listen more often to information that confirms our existing beliefs.
Some examples include:
- Only paying attention to information (e.g., from dividend investors) that confirms your beliefs about items (e.g., dividends) and ignores other information.
- Not considering all of the facts.
The result is that two people, on two sides of an issue, could be polarized. They could easily walk off with a very different interpretation of the same fact. It could lead to the inability to even listen, and entertain any different view.
2. Hindsight Bias
This bias includes the tendency to see events, even random ones, as more predictable than they really are.
Some examples include:
- Insisting that you knew all along the stock market was going to crash.
- Believing you could have easily predicted which stocks would become profitable over time.
This bias occurs for many reasons, including our natural tendency to simplify events in our mind, or just see events differently than they are.
3. Anchoring Bias
This is one of Kahneman’s favourites!
This bias includes the tendency to be overly influenced by the first part of information we hear. We get rooted in that information, as irrelevant as it might be.
Some examples include:
- The first number voiced during a price negotiation typically becomes the anchoring point on which all further price negotiations are based.
- Doctors can become susceptible to the anchoring bias themselves when diagnosing patients. The physician’s first impressions of the patient often create an anchoring point that can sometimes incorrectly influence all subsequent diagnostic assessments.
Like other cognitive biases, anchoring can have an effect on the decisions you make each day. For instance, it can influence how much you are willing to pay for your home, a car, or your groceries.
The original explanation for anchoring bias comes from, again, Amos Tversky and Daniel Kahneman. In a 1974 paper called “Judgment under Uncertainty: Heuristics and Biases,” Tversky and Kahneman theorized that, when people try to make estimates or predictions, they begin with some initial value or starting point, and then adjust from there. Anchoring bias happens because the adjustments usually aren’t big enough, leading us to incorrect decisions. This has become known as the anchor-and-adjust hypothesis.
To back up their account of anchoring, Tversky and Kahneman ran a study where they had high school students guess the answers to mathematical equations in a very short period of time. Within five seconds, the students were asked to estimate the product:
- 8 x 7 x 6 x 5 x 4 x 3 x 2 x 1
Another group was given the same sequence, but in reverse:
- 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8
The media estimate for the first problem was 2,250, while the median estimate for the second was 512. (The correct answer is 40,320.) You can see here from this experiment, the group who was given the descending sequence was working with larger numbers to start with, so their partial calculations brought them to a larger starting point, which they became anchored to (and vice-versa for the other group).
You can appreciate now how anchoring is so common, for so many things. We often underestimate the time it takes to do things or work with others on things. You can appreciate how significant these consequences are in the business world when things don’t run on time or on budget or both!
4. Actor-Observer Bias
This bias includes the tendency to attribute our actions to external influences and other people’s actions to internal ones. Meaning, we can be heavily influenced by whether we are the actor or the observer in a given situation.
- You might say you sold a stock at the wrong time because the market conditions demanded it.
- You heard a friend say they sold a stock at the wrong time, because they lacked investing discipline, and not because the same market conditions demanded it.
As actors, we live through experiences, putting a bias on those things that influence our decision-making. As observers, we make assumptions about others, because we cannot see nor feel what they are thinking about.
5. The Self-Serving Bias
Just as it reads!
This bias includes the tendency for people to give themselves credit for successes but lay the blame for failures on outside causes. So, when things go right – you were smart. When things go wrong, it was bad luck given how smart you are. 🙂
Some examples include:
- Attributing good grades to being smart.
- Attributing your successful stock selection is based on data nobody else has thought of.
This one is tricky because as you age, you gain experience, and you might consider your wisdom as smarts – to take more credit for things going well when many other variables were actually involved.
6. The Halo Effect
No list would be complete without the halo effect.
This bias includes the tendency for an initial impression of a person to influence what we think of them overall.
Some examples include:
- Thinking people who are good-looking are also smarter (for stock selection!) than less attractive people
- Thinking that a potential U.S. political candidate (who is a businessman) may also be a competent U.S. President. (Ha.)
Kidding aside, this bias can be huge. For example, can you imagine thinking because a financial advisor is attractive they are also competent and smart?
Beyond this list, there is also:
The availability heuristic – the tendency to estimate the probability of something happening based on how many examples readily come to mind.
The representative heuristic – the tendency to make judgments based on comparisons to something else in mind.
Regression to the mean – the tendency to make biased predictions about the future, because we fail to take into account the power of regression. Here’s an example explained by Kahneman in his book, Thinking Fast and Slow:
“Depressed children treated with an energy drink improve significantly over a three-month period. I made up this newspaper headline, but the fact it reports is true: if you treated a group of depressed children for some time with an energy drink, they would show a clinically significant improvement.
It is also the case that depressed children who spend some time standing on their head or hug a cat for twenty minutes a day will also show improvement.”
Optimism bias – the tendency for us to believe we are less likely to suffer from misfortune and more likely to attain success than our peers.
The Dunning-Kruger effect – the tendency for us to believe that some people are smarter and more capable than they really are. For example, some people can’t recognize or rationalize their own incompetence.
Be Mindful of these Personal Finance Biases (Summary)
- Emotional attachments to decisions, and money is a big one.
- Individual motivations or desires, including egos to support.
- Social pressures including those from co-workers, friends, family members.
- Our finite ability to process information.
So, if we had to think about everything, methodically and equally, very logically like Mr. Spock we probably wouldn’t make many decisions!
To minimize but not avoid biases, consider the following:
- Be aware you have biases and consider how your biases may impact your decision-making.
- Consider other factors that might be influencing your decisions, emotions being one of them.
- Challenge your assumptions from time to time and practice continuous learning about you and the world around you.
While many cognitive biases exist, even more beyond this list, we believe biases are generally helpful – to help make sense of the world around us including some work on decision-making, for personal finance decisions too!
As individuals, we’d all like to believe our superior big-brain expertise and knowledge are enough to make good decisions. The reality is, and Kahneman’s work has proved this, our minds are flawed and we can make systematic errors – leading to costly mistakes and poor outcomes. Simply put, because of biases, very smart and intelligent people can and do make very bad decisions.
We hope you enjoyed this post and we look forward to posting more free content over time!
Mark & Joe.