Imagine standing at a fork in the road, one path leads to long-term financial success, and the other towards financial stagnation or worse, downfall. What if I told you that the direction you choose may often be influenced not by clear financial logic, but by invisible cognitive biases deeply ingrained in our brains?
Cognitive biases in behavioral finance refer to the systematic patterns of thinking and decision-making errors that can occur due to mental shortcuts and distortions, significantly impacting how individuals perceive and react to financial information and make investment choices.
Cognitive biases, those hardwired quirks of our minds, can significantly influence our financial decisions, often leading us astray. They are like optical illusions that fool our brains into seeing things that aren’t there or missing things that are right in front of us.
In this post, we’ll uncover some of the most common cognitive biases that impact financial decision-making and offer actionable tips to overcome them. Whether you’re a seasoned investor, a personal finance enthusiast, or someone just beginning your financial journey, this piece is a must-read. Let’s equip ourselves with the knowledge to outsmart our own minds and make better financial decisions!
What are Cognitive Biases?
Cognitive biases are patterns of behavior that lead us to make irrational decisions. They’re a result of our brains making automatic assumptions based on heuristics – mental shortcuts that simplify our decision-making. They’re like shorthand rules that our brains use to make sense of the world around us. Because they’re automatic, they’re largely hidden from view – making it harder to identify and correct them. Identifying and correcting our cognitive biases is essential if we want to make sound financial decisions. Cognitive biases are also universal – meaning that everyone experiences them, regardless of their level of education or ability. They can be especially damaging to finances because they can lead us to make decisions that are contrary to our own best interests. For example, cognitive biases can lead us to take unnecessary risks and ignore warning signs, putting our money in jeopardy.
Common Cognitive Biases
Overconfidence Bias
People tend to be overconfident in their abilities, which can lead to poor decision-making. In one experiment, people were asked to rank their driving skill on a scale from “poor” to “excellent.” Then, they were asked if they had been in any car accidents in the past 5 years. Only 11% of people who had been in a car accident in the past 5 years ranked themselves “poor” or “fair.” That means 89% of people who had been in car accidents were still overly confident in their driving ability. If you find yourself overestimating your skills in areas like driving, work, or sports, you could be setting yourself up for failure. If you’re overconfident in your ability to drive, you may be less careful than you should be around other drivers or pedestrians. An overconfidence bias can cause you to take risks you otherwise wouldn’t.
Confirmation Bias
Confirmation bias is to look for or interpret information in a way that confirms your existing beliefs. It can also refer to looking for information that supports a decision you’ve already made. Confirmation bias can lead you to ignore information that contradicts your beliefs and focus on information that supports your point of view.
Anchoring Bias
Anchoring is a cognitive bias about relying heavily on the first piece of information you’re given when making a decision. For example, say you’re choosing between two job offers. You’ve been looking for work for a while and you’re excited to have two offers. You may look at the salary for each job and compare them to the salary you’ve been making. You may then decide which job to choose based on that salary alone. If you’re basing your decision on the first piece of information you’re given, such as the salary on a job offer, you may find yourself making an unwise decision. You may be ignoring other important factors that may impact your decision, such as the long-term growth potential of the job or the cost of living in the area.
Loss Aversion Bias
Loss aversion refers to the tendency to strongly prefer avoiding losses over acquiring gains. In other words, you’d rather avoid taking a risk than you would like to take a risk that could lead to a reward. You may decide not to apply for a job you’re qualified for because you’re afraid you might not get the job. You’re more concerned about the risk of not getting the job than you are excited about acquiring a new job. Similarly, you may decide not to go on a date because you’re afraid you might not have a good time. You’d rather avoid that negative experience than potentially have a great time. Loss aversion can cause you to miss out on opportunities that could be beneficial to you.
Status Quo Bias
When an action you’ve taken has led to a positive outcome, you may be more likely to rely on that same action in the future. When an action you’ve taken has led to a negative outcome, you may be more likely to avoid that same action in the future. This is known as status quo bias. Status quo bias can negatively impact decision-making by leading you to overvalue the status quo and undervalue new ideas. It can be helpful to keep this bias in mind when making new decisions, and actively try to account for it. You can do this by identifying potential biases, being open to new ideas, and challenging your existing assumptions.
Hindsight bias
Hindsight bias is an error in judgment in which past events are perceived as being more predictable than they actually were. This error in judgment is due to the tendency to retroactively dismiss the role that chance and uncertainty played in an event and attribute it solely to your knowledge of the outcome. Hindsight bias can lead you to believe that you knew what would happen all along, even when the outcome was far from certain. It is important to recognize hindsight bias when making decisions, especially those that have significant repercussions. Avoiding hindsight bias can help you make more objective decisions, especially in situations where the outcome is far from certain.
Availability Bias
Availability bias is about believing that more frequent or recent examples are more likely to occur in the future. This is often because we place a disproportionate amount of importance on recent examples. For example, if you’ve suffered two losses in the stock market in the past year, you may be more likely to believe that the market will drop in the future, even if the data would suggest otherwise. Availability bias can be helpful in some cases, such as when you want to be prepared for the worst-case scenario, but it can also lead you to make suboptimal decisions. You can reduce the impact of availability bias by actively challenging your assumptions and looking for alternative explanations.
Loss Aversion Bias
Loss aversion means that losses are more psychologically impactful than equivalent gains. For example, if you lose £100, you’ll most likely feel that loss more than if you’d made £100. Loss aversion can negatively impact decision-making by leading you to focus excessively on potential losses and ignore potential gains. This can lead you to make suboptimal decisions by putting too much weight on the negative aspects of a particular decision. One way to reduce the impact of loss aversion is to actively consider positive outcomes as well as negative ones.
Survivorship Bias
Survivorship bias is a logical error that occurs when we focus on the successful elements of a situation and ignore the failures. It’s a cognitive bias that can lead to false assumptions and can have serious consequences. For example, when studying the success of a business, it might be easy to overlook the failed businesses that never made it in that same market. We can mistakenly think that all businesses in that field are successful, when in fact that’s not the case. This bias can also lead us to focus on the most popular products and services, leading us to overlook any potential improvements or innovations.
To avoid survivorship bias, it’s important to take a big-picture approach when analyzing a situation. It’s important to consider the successes and failures, as well as the underlying factors that allowed some to succeed while others failed. This can help us to make more informed decisions and to avoid making assumptions based on limited information.
How Cognitive Biases Influence Financial Decision Making
Cognitive biases can lead us to make hasty and illogical financial decisions. This includes investing in high-risk assets when more stable options exist and taking unnecessary financial risks that jeopardize our financial well-being.
For example, being aware of cognitive biases is crucial for investing in the stock market. Confirmation bias can make us seek information that confirms our existing beliefs about a stock, ignoring contradictory evidence.
Another case might be, the status quo bias is the tendency for us to stick with our current course of action, even when there are more promising stocks available. This can lead us to stick with an inferior investment option simply because we’re used to it.
Cognitive biases can also lead us to see danger where it doesn’t exist. This can lead us to respond to situations with excessive caution and miss out on valuable opportunities. Cognitive biases cause us to interpret risk in an arbitrary way. This can cause us to misread warning signs and react to situations in an unwarranted manner.
Examples of Cognitive Biases in Financial Decision Making
Investing too heavily in a particular asset – This is a classic case of the status quo bias. We become too comfortable with the asset we’re currently invested in and fail to re-evaluate our holdings. This can lead us to invest too heavily in one particular asset, neglecting others that might be a better investment option.
Cognitive ease leads us to overlook a viable alternative – This is a result of us selecting the option that is easier to digest and process. We fail to consider viable alternatives, simply because they’re more difficult to understand. This can lead us to overlook a more financially sound option.
Cognitive load leading us to make hasty and irrational decisions – When too much is asked of us, we’re more likely to make hasty and irrational decisions. This can lead us to jump at the first opportunity we see, without properly researching it.
Psychological Biases and Heuristics in Mediocristan vs. Extremistan
In his book “The Black Swan,” Nassim Nicholas Taleb introduces the concepts of “Mediocristan” and “Extremistan” to describe two different types of distributions that can occur in real-world data.
Mediocristan is a term used to describe a distribution of data that is characterized by a relatively small number of extreme events. This type of distribution is typically found in situations where the underlying data is generated by a stable and well-defined process, and where the distribution of outcomes is relatively predictable. Examples of Mediocristan might include things like the heights of people in a population or the scores on a standardized test.
Extremistan, on the other hand, is a term used to describe a distribution of data that is characterized by a large number of extreme events. This type of distribution is typically found in situations where the underlying data is generated by a complex and poorly understood process, and where the distribution of outcomes is highly unpredictable. Examples of Extremistan might include things like the wealth of individuals in a population or the stock market.
Taleb argues that most people tend to think about the world in terms of Mediocristan because it is easier to understand and predict. However, he suggests that many of the most important events in the world (such as technological breakthroughs, political revolutions, and financial crises) are actually driven by Extremistan dynamics and that this can lead people to be overly confident in their ability to predict the future.
In Mediocristan, the consequences of irrational decision-making caused by psychological biases and heuristics are likely to be relatively small, because the distribution of outcomes is relatively predictable and stable. For example, if a person makes a decision based on a cognitive bias like the sunk cost fallacy, they may waste a small amount of time or money. The overall impact on their life is likely to be relatively minor.
On the other hand, in Extremistan, irrational decision-making caused by psychological biases and heuristics can have disastrous systemic consequences because the distribution of outcomes is highly unpredictable and volatile. This means that a single decision, or a small number of decisions, can have far-reaching and unintended consequences that ripple through the system as a whole.
Here are a few examples of how irrational decision-making in Extremistan could lead to disastrous systemic consequences:
- Financial markets: Irrational decision-making by investors and traders, influenced by psychological biases and heuristics, can lead to financial bubbles, market crashes, and other types of financial instability that have negative impacts on the economy as a whole. Cognitive biases can play a significant role in shaping market sentiment.
- Political systems: Irrational decision-making by voters and politicians, influenced by psychological biases and heuristics, can lead to the election of leaders who pursue misguided or harmful policies, or to the adoption of policies that are based on misinformation or propaganda.
- Environmental systems: Irrational decision-making by individuals, businesses, and governments, influenced by psychological biases and heuristics, can contribute to environmental problems such as climate change, pollution, and habitat destruction, which have negative impacts on the planet as a whole.
Overall, it is important to recognize the role that psychological biases and heuristics can play in decision-making and to take steps to mitigate their influence in order to avoid disastrous systemic consequences in Extremistan.
That is the reason why even though everyone knew about fallacies 2 millennia ago, research about it started recently.
Strategies for Overcoming Cognitive Biases
It’s important to recognize and understand our cognitive biases if we want to make sound financial decisions.
- Recognize the existence of cognitive biases: Awareness is the first step in overcoming cognitive biases. Understand that biases are a natural part of human thinking and can influence financial decision-making.
- Educate yourself: Learn about different types of cognitive biases that commonly affect financial decisions, such as confirmation bias, anchoring bias, and loss aversion. Understanding these biases can help you identify them when they occur.
- Gather diverse information: Seek out different perspectives and sources of information before making financial decisions. This can help you avoid confirmation bias, where you selectively focus on information that supports your existing beliefs.
- Take your time: Avoid making impulsive decisions. Allow yourself enough time to analyze and consider different options. Rushing into decisions can lead to poor financial outcomes due to biases like anchoring and availability bias.
- Develop a decision-making framework: Establish a systematic approach to decision-making. This could involve creating a checklist of factors to consider, setting specific criteria, or using quantitative models to assess the potential outcomes of different choices.
- Challenge your assumptions: Question your own beliefs and assumptions before making financial decisions. This can help mitigate biases like overconfidence bias and representativeness bias.
- Seek advice from others: Consult with trusted friends, family members, or financial professionals. Their perspectives can provide valuable insights and counteract biases like overconfidence and confirmation bias.
- Track your past decisions and outcomes: Maintain a record of your financial decisions and their outcomes. This retrospective analysis can help you identify patterns and biases that may have influenced your choices. Learning from past mistakes is crucial in improving decision-making.
- Consider the long-term perspective: Think about the long-term implications of your financial decisions rather than focusing solely on short-term gains or losses. This can help overcome biases like myopic loss aversion and present bias.
- Embrace a rational mindset: Strive to think logically and objectively when making financial decisions. Be aware of emotions that can cloud judgment, such as fear or greed. Recognize that cognitive biases can lead to irrational behavior and work to counteract them.
Conclusion
The post-modern age, characterized by rapid technological development, information overload, and a constant barrage of choices, can often amplify our innate biases.
Post-modern age, with its focus on relativity, plurality, and the subjectivity of perception, adds another layer of complexity to our decision-making processes. The abundance of perspectives and choices available can often lead us down the path of analysis paralysis, confirmation bias, or overconfidence. And the effect of the biases and fallacies in our decision-making process can have costly consequences since we live in a world that is increasingly carrying the characteristics of “extremistan” by Nassim Taleb’s definition.
Understanding and recognizing these biases is essential for investors and individuals navigating the complex world of finance. By being aware of our own cognitive tendencies and implementing strategies to mitigate their effects, we can make more rational and informed choices. Overcoming cognitive biases requires ongoing self-reflection, education, and a commitment to challenging our own assumptions. By doing so, we can strive to make better financial decisions and ultimately achieve our long-term goals.
An accomplished financial analyst and writer, holds a Master’s degree in Finance from the University of Exeter, bringing his expertise to guide readers through the world of financial markets and investment strategies.
He has a special interest in the confluence of psychology and financial decision-making. His articles delve into the intricacies of financial markets, offering readers a keen understanding of complex economic trends and investment dynamics.
As an expert in the world of finance, possesses an in-depth knowledge of various investment vehicles, equity markets, and risk management strategies. He expertly navigates the complexities of the financial landscape, providing readers with actionable insights into stock market trends, bonds, derivatives, and other forms of investments.
With a keen interest in behavioral finance, he explores the fascinating interplay between human psychology and financial decision-making. He decodes the biases and irrational behaviors that often lead to sub-optimal financial decisions, offering readers strategies to overcome these pitfalls and make more informed, profitable choices.
Beyond individual investments, the author shines a light on macroeconomic indicators and their impacts on the financial markets. His articles help readers understand the ripple effects of policy changes, market volatility, and global events on their investments, equipping them with the knowledge to navigate these uncertainties.
