Navigating Bias and Beliefs
“Ego, Emotion, Information, Attention, and Conservation. The number of bad decisions we can make is limitless (have you seen reality TV?), but all behavioral risk has one or more of these five risk factors at its core.”
Imagine you’re in the market for a car. You visit a dealership, and the salesperson starts by showing you the higher-priced luxury cars—sleek, shiny, and loaded with features. Your initial impression is that these cars are out of your budget.
Next, the salesperson guides you to the back of the lot, where you see a row of more affordable vehicles. Suddenly, these seem like a great deal compared to the expensive options you just saw. You’re anchored to the initial high prices, so anything lower feels like a bargain.
In reality, all the cars might be overpriced, but the anchoring effect has skewed your perception. By setting that initial anchor with the luxury cars, the dealer influenced how you evaluate the value of the used cars.
Anchoring is not the only bias we can be vulnerable to when it's time to spend, invest, or make other money moves. I’m going to share 5 behavioral biases that can misguide us when it's time to spend, invest, or make other money moves.
1. Herd Mentality
It's common to feel drawn to follow the crowd and mimic what everyone else is doing - this is known as the herd mentality. Often, we might believe that the group has superior knowledge and quickly join in without much consideration.
Example: Several of your friends invested in a company that just started trading via an IPO (Initial Public Offering), so you jump in and purchase shares before doing any research on the company.
Red Flag: “If I don’t buy shares now, I’ll miss my chance.”
Ever heard of the fear of missing out (FOMO)? It's that feeling that can sometimes make us act on impulse because we're worried about falling behind or not being part of the latest trend. This fear often stems from the herd mentality, where we feel the need to stay relevant and grab our share of opportunities before they're gone.
2. Overconfidence
It's wonderful to feel confident in our financial knowledge and skills, extending beyond just money matters. You should be proud of your accomplishments! However, it's important to be wary of slipping into overconfidence. This shift can happen when our self-assurance blurs the line between what we do know and what we might not. It can lead us to make hasty decisions based on misguided boldness. Let's stay mindful of balancing confidence with humility to make the best choices for our financial well-being.
Example: Traders often suffer from overconfidence bias. They believe they can predict market directions better than others. This confidence can lead to excessive risk-taking and financial overextensions.
Red Flag: “I’ve traded markets like this before.”
Making sound financial decisions is crucial, as our past experiences play a key role. However, it's important to remember that relying solely on past experiences can sometimes lead us to believe we have complete control, potentially exposing us to unexpected risks.
3. Loss Aversion
Loss aversion can have a powerful impact on how we perceive wins and losses. It's natural for us to feel the sting of a loss more deeply than the joy of a win - our brains are wired that way to protect us. However, this tendency can sometimes lead us to focus more on the negatives and avoid taking risks or making changes that could benefit us in the long run. By understanding this aspect of human behavior, we can learn to strike a balance between caution and opportunity in our financial decisions.
Example: An investor might hold onto a losing stock longer than they should, hoping it will recover. The fear of realizing a loss outweighs the rational analysis.
Red Flag: “I’ll hold and see what happens.”
If you’re rationalizing a decision to hold onto a losing investment, you could be experiencing loss aversion bias.
4. Confirmation Bias
Confirmation bias is totally normal, but it's essential to be aware of it. This bias occurs when we unintentionally stick to our own beliefs to avoid feeling uncomfortable or challenged. It's like staying in a cozy bubble of familiar ideas because venturing out into unfamiliar territory seems daunting.
By only seeking information that aligns with what we already think, we might be missing out on valuable insights. Exploring different perspectives, even ones that contradict our own, can actually help us grow financially and stay connected to the world around us. So, let's remember to stay open-minded and embrace the richness that diverse viewpoints can bring to our financial journeys!
Example: Imagine if an investor catches wind of a rumor suggesting that a company is close to declaring bankruptcy. Fueled by this information, the investor contemplates selling the stock. However, when they hop online to catch up on the company's latest news, they focus solely on articles reinforcing the impending bankruptcy, overlooking any positive news on the company.
Red Flag: “I know I’m right because...”
When you consistently practice this type of thinking, you may unintentionally reinforce your existing beliefs, leading to confirmation bias. This can result in you rationalizing your decisions rather than critically evaluating them to gain a more well-rounded perspective.
5. Anchoring
I shared a story in the beginning of this newsletter on how anchoring bias will cause us to rely heavily on the first piece of information we receive when making decisions. This initial nugget of information becomes our "anchor," influencing how we assess present and future situations.
Example: A stock priced at $150 a share last month is now trading at $40 a share, making it seem like a value. However, if you just saw the stock today for the first time at $40 a share (without anchoring to the $150 price), it wouldn’t necessarily seem to be a value.
Red Flag: “It could be worse, so I should...”
We may tend to focus heavily on one specific set of data points, whether they are from the past or the present, in order to predict what might happen in the future. This can sometimes cause us to accidentally ignore other valuable evidence or trends that should actually be taken into account for a more well-rounded perspective.
Action Items
Have you ever noticed any of these biases in your own experiences? Were there any that caught you by surprise? It's important to remember that none of us are perfect, and we all make imperfect choices at times. Our biases and emotions can sometimes cloud our judgment, leading us to rely on faulty reasoning, unclear memories, or flawed intuition when it comes to important financial decisions.
Instead of letting these biases control us, we can learn to adapt. One way to start is by acknowledging our biases and becoming more conscious of how our emotions influence our financial decisions. By doing so, we can establish a better foundation for evaluating our financial moves and create a systematic approach that minimizes the impact of emotions.
Increasing our financial literacy can also help us identify and address our biases more effectively. It's beneficial to regularly seek input from trusted individuals for a fresh perspective, valuable input, and a critical checkpoint before making significant financial decisions. These steps can guide us in focusing on our long-term objectives and making sensible choices that align with our financial goals.
~Alex
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