This post on biases is structured into 3 parts:
- Part 1: Understanding Biases and Their Impact on Decision-Making
- Part 2: Individual Biases That Lead to Bad Financial Decisions
- Part 3: How Biases Influence Financial and Investment Decisions
Part 1: Understanding Biases and Their Impact on Decision-Making
What Are Biases?
Biases are cognitive shortcuts our brains take when processing information. They help us make decisions quickly and efficiently, but they often lead to errors in judgment. These shortcuts are the result of evolution, where quick decisions—based on incomplete information—often meant the difference between survival and failure. In modern life, these cognitive shortcuts, or cognitive biases, still play a role, but they can also lead us astray, especially in complex environments like finance and investing.
Our biases are heavily influenced by emotions, past experiences, and social pressures. Instead of processing all the information available to us in an objective manner, we often rely on these mental shortcuts, which can distort our thinking. This distortion can have significant consequences when it comes to managing money, leading to impulsive decisions or behaviors that may not align with long-term financial goals.
What Do Biases Make You Do?
Biases can lead to irrational financial behavior. While logic and data should ideally drive decisions about investing, saving, and spending, biases push us toward emotional reactions. Some common things biases make you do include:
- Acting impulsively: Making a hasty financial decision without fully considering the consequences.
- Overestimating your knowledge: Believing you’re more knowledgeable about investments or the market than you actually are.
- Holding onto losses: Failing to cut losses because of an emotional attachment to a particular investment.
- Following the crowd: Making decisions based on what others are doing rather than what’s best for you.
- Overemphasizing recent events: Giving too much weight to recent information or trends when making financial decisions.
Part 2: Individual Biases That Lead to Bad Financial Decisions
Let’s dive into specific cognitive biases that lead to poor financial choices, from overspending to bad investment strategies.
Confirmation Bias
- What it is: Confirmation bias occurs when you actively seek out information that confirms your existing beliefs and ignore information that contradicts them. For instance, if you believe a stock will perform well, you might only pay attention to news and reports that reinforce your opinion while disregarding negative information.
- Impact: Investors may hold onto a losing stock for too long, ignoring warning signs and only focusing on positive news that validates their original decision. This can result in significant losses when the reality of a company’s poor performance becomes undeniable.
Overconfidence Bias
- What it is: Overconfidence bias happens when people overestimate their knowledge, skills, or ability to predict outcomes. In finance, this often leads investors to take on more risk than they should or believe they can consistently beat the market.
- Impact: Overconfidence can result in frequent trading, poor stock selection, and underestimating risks. Investors who think they know more than they do may ignore the fundamentals and make impulsive decisions, often leading to lower overall returns.
Anchoring Bias
- What it is: Anchoring bias is the tendency to rely too heavily on the first piece of information you encounter (the “anchor”) when making decisions. Even if new information is presented, we tend to be stuck on the initial anchor.
- Impact: For example, if you buy a stock at $100, you may anchor to that price and refuse to sell it if it drops below that level, even when it’s clear that the stock’s fundamentals have changed. This can result in holding onto losses for too long.
Loss Aversion
- What it is: Loss aversion is the tendency to feel the pain of losses much more acutely than the pleasure of gains. This bias leads to an irrational fear of losing money, which can cloud judgment.
- Impact: Investors with loss aversion may avoid selling losing investments because they don’t want to “lock in” the loss, leading to larger losses down the road. They might also avoid taking necessary risks in fear of losing money, missing out on potential gains.
Herding Bias
- What it is: Herding bias refers to the tendency to follow what others are doing, assuming that if many people are making the same decision, it must be the correct one.
- Impact: This bias can lead to buying during a market bubble or selling during a crash. Herding behaviour was a major factor in both the dot-com bubble of the late 1990s and the housing market crash of 2008, as investors followed the crowd into overvalued assets.
Recency Bias
- What it is: Recency bias happens when people place too much importance on recent events, assuming they are indicative of future trends.
- Impact: After a bull market, investors may become overly optimistic, assuming that the trend will continue indefinitely, which can lead to overexposure to risk. Conversely, after a market downturn, they might become overly pessimistic and sell investments at a loss, fearing further decline.
Mental Accounting
- What it is: Mental accounting is the tendency to treat money differently depending on its source or intended use. People often assign arbitrary values to money based on its origin rather than its total impact on their finances.
- Impact: Investors might treat tax refunds or bonuses as “extra” money and take higher risks with it than they would with their regular income. This behaviour can lead to poor investment decisions, as money is fungible and should be treated equally regardless of its source.
Sunk Cost Fallacy
- What it is: The sunk cost fallacy is the tendency to continue investing in something simply because you’ve already invested time, money, or resources into it, even if it’s no longer a rational decision.
- Impact: This bias often leads investors to throw good money after bad by holding onto a losing investment in the hope that it will turn around, rather than cutting their losses and moving on.
There are plenty more biases making you do stupid things for your money, but I think you get the idea. It is critical to be aware of those biases not only as investors but as humans as they can negatively impact our life. Only if you are aware of those biases you can avoid or at least reduce their impact on your life.
Part 3: How Biases Influence Financial and Investment Decisions
Biases can have a profound impact on how individuals manage their money and make investment decisions. Below are some common examples of how biases manifest in the world of finance.
Impulsive Buying and Spending
Biases like recency bias and overconfidence often lead to impulsive spending. For instance, after a period of financial success or market gains, people may feel more confident and willing to spend more on luxury items, vacations, or other discretionary expenses. This impulsive behaviour can lead to overspending and difficulty maintaining a budget, undermining long-term financial goals like saving and investing.
Poor Investment Timing
Many investors fall victim to herding bias and recency bias when it comes to timing the market. They may buy stocks during a bull market, convinced that prices will continue to rise indefinitely, only to face losses when the market corrects. Conversely, they may sell during a downturn out of fear, crystallizing losses. These behaviours often result in buying high and selling low – the exact opposite of a sound investment strategy.
Holding Onto Losing Investments
Loss aversion, anchoring, and the sunk cost fallacy are common reasons why investors hold onto losing investments. The emotional pain of realizing a loss can be so intense that they refuse to sell, even when the investment has little chance of recovery. Investors may also anchor to a specific price (like the price they originally paid) and wait for the asset to return to that level, even when market conditions suggest otherwise.
Overtrading
Investors influenced by overconfidence bias often believe they have the skills to beat the market through frequent trading. However, studies show that excessive trading usually leads to underperformance due to transaction costs, taxes, and the difficulty of timing the market consistently. Confirmation bias can compound this problem, as traders may only seek out information that supports their strategy, reinforcing their overconfidence.
Overemphasis on Short-Term Results
Biases like recency bias lead investors to focus too much on short-term gains or losses. In periods of market volatility, this short-term focus can cause panic, leading to rash decisions like selling off investments during downturns. Investors with a long-term perspective tend to fare better, as they are less likely to be influenced by short-term market fluctuations.
Failing to Diversify
Investors influenced by mental accounting or confirmation bias may fail to diversify their portfolio properly. For example, they may hold a large portion of their wealth in their employer’s stock because they feel emotionally attached to the company or because they believe in its future success. This concentration of assets can lead to significant risk if the company underperforms.
Missing Out on Growth Opportunities
Loss aversion can cause investors to be overly cautious, avoiding risk altogether. While being risk-averse can protect against losses, it can also result in missed opportunities for growth. For example, keeping a large portion of assets in cash or low-risk investments might feel safe, but it can lead to stagnation, especially in times of inflation or when markets are booming.
Conclusion
Biases are deeply ingrained in human psychology, and they can have a profound effect on financial decisions. By understanding how biases like overconfidence, loss aversion, and confirmation bias work, you can take steps to minimize their impact. Financial success often comes from disciplined, rational decision-making, and awareness of these cognitive traps is the first step toward making better financial choices. Whether you’re spending, saving, or investing, learning to recognize and manage these biases will help you avoid making decisions that could harm your financial future.
Further Reading