7 Cognitive Biases That May Be Influencing Your Financial Decisions
These Cognitive Biases Could Be Influencing Your Decision Making Process
The human brain is flat-out amazing. It's brought humans from caves to high-rises, from handprint art to the Mona Lisa, from barely seeing over the horizon to peering into deep space – all while regulating our heartbeats and breathing.
But nature’s most impressive creation has its flaws. Among these is “cognitive bias,” the tendency for the brain to make an irrational, subjective judgment despite its possession of facts and arguments against that decision.
These subconscious biases are so powerful they often overwhelm our reasoning, values, and morals. They explain why female scientists are inclined to hire male scientists – and pay them more than female peers. Or why blonde women in Australia earn an average 7% more than brunettes. And why people with “mature” faces have more career success than baby-faced colleagues, according to a Duke University study.
Cognitive biases can degrade all types of decisions, including those related to money and investing. So it’s vital to get them under control. The first step in that process is awareness. Here are some of the many cognitive biases that might be undermining your critical thinking.
Halo/Horn – Your mother was right: first impressions are crucial. If we have a good initial experience with a person or thing, we tend to believe our experiences will always be good. This belief continues even after that person or thing disappoints us in a later interaction.
The same is true of negative experiences. We allow a bad first experience to define our thinking. I see the horn bias in people who tell me they lost money in the stock market in their early 20’s and therefore will never invest again – even as the market has risen steadily in the intervening 25 years.
Bandwagon – The lemming bias. Our mind tells us that if everyone else is doing something, it must be the right thing to do. Examples: Buying too much house during the housing boom, or over-investing in gold during times of uncertainty.
Confirmation – Possibly the most common bias. This is our tendency to hunt and accept information that supports what we already believe, or want to believe. The result is that we aren’t always open to new ideas or opportunities, including investing early on in companies with disruptive ideas, like Netflix or Amazon.
Affect Heuristic – How things are presented makes a big difference to how our mind perceives them. In one study, for example, participants believed that a disease that killed 1,286 people out of 10,000 was more deadly than one with a 24.14% mortality rate. Why? Because the image of 1,286 people dying was more powerful than a statistic. It’s especially important to be mindful of the affect heuristic bias when considering financial decisions, which are packed with numbers that can be presented in various ways by investment salespeople and others with an agenda.
Ostrich – We’ve all done this. When faced with a tough situation our brain will rationalize putting off hard decisions and actions – even when that’s counter-productive.
Congress has been doing this for years with Social Security and the federal budget – kicking the can down the road.
Planning fallacy – We convince ourselves that we can perform tasks faster than we can, so we overbook our schedules and say yes to every request. The frequent result is overpromising and under-delivering.
Bias Blindspot – This sneaky bias might the most dangerous of all. It happens when we think we’ve overcome our biases and always make totally rational, fact-based decisions. That mindset leaves us terribly vulnerable to making bad calls.
It’s important to be mindful of these potential biases as you consider important financial matters. If you suspect you might be operating under a bias, take another long hard look at the facts and apply whatever lessons you might have learned from similar past experiences.
The result will be better decisions and faster progress towards your money goals.