Hello and welcome back to Simple Money podcast!
Today we go deep – deep into the psyche of a us – humans. Where we look at the major types of cognitive bias that affect our personal finance and investment. These internalized decision-making techniques can seriously affect our financial choices – for the better or worse – and understanding them can give us a greater understanding of our behaviors and why we make certain decisions.
What Are Cognitive Biases?
Biases are often defined as a tendency, prejudice, or inclination towards or against something. They are deviations from the norms or rationality of judgement and create our own subjective reality. Biases can be positive – such as a habit of avoiding sugar or avoiding something dangerous. They can also be harmful, such as prejudices against certain groups of people or harmful behavior.
Cognitive Biases are essentially mental short-cuts that are based on existent on preexisting beliefs that are often not rooted in knowledge. This can then lead to unreasonable or inaccurate conclusions.
In some cases, biases come from Heuristics. Generally described, Heuristics are a mental rule of thumb that we have developed over time to assist with problem solving or analysis. These are essentially quick rules that can help us navigate frequent decisions without having to put the energy into making a detailed decision again. This can be handy when it’s a simple issue like what you should wear for the day or what to have for lunch, but can be damaging if it leads you into repeating a similar error.
And this all circles back to how these types of behavior can really affect how an individual manages their finances and invests. Traditional economic theory assumes that individuals are rational, have access to information and make consistent choices. However, a growing amount of research into investor behavior indicates otherwise.
Biases: Trend Chasing
One of the most common type of Biases come from chasing trends – basically just investing in what everyone else is doing. On the surface it seems like it’s the right behavior that is working and we don’t want to miss out. Unfortunately, what often happens here is that one shows up late to the party and performance of these trendy investments are lacking.
Researchers on behavioral finance found that 39% of all new money committed to mutual funds went into the 10% of funds with the best performance the prior year and additional research from The University of California found that investors who based their decisions on past performance had worse performance than others.
This shows something that we have seen quite a often. As more attention is given to a specific asset – such as a stock – more people jump on the bandwagon. Recently we saw happen with Cryptocurrency and marijuana stocks. Some people did well, but some were badly burned – usually those that jumped on the trend at the end.
Bias: Endowment Bias
Another bias that we see frequently is called the endowment bias. The way that this bias works is that when we overvalue an asset that we own in comparison if they were buying the same asset. The individual overvalues an asset that they own – even if it’s irrational. A perfect example of this is when a friend tries to sell something for much more than it’s worth or if you have ever experienced a garage sale where the seller over-prices items.
From a larger perspective, this can cause someone to hold onto assets for longer than is required and in the most extreme case can lead to hoarding. If an asset is held long enough, it may completely lose it’s value. In some cases, one may irrationally overvalue investments leading them to hold on to them for longer than would typically be recommended. Causing greater losses and missing out on other opportunities.
Bias: Regret Aversion
The last bias that we’re going to over today is regret aversion. This bias is caused when we are afraid of making a decision that we regret and don’t act because of this. This type of bias can come out in many forms, including accepting less risk and holding on to investments that are under performing.
This can lead someone to not make important investment choices or not selling an investment that is under performing. This can lead someone to choose guaranteed investment or savings options over investments that have greater expected performance. The consequence is that they would have to put more money aside to make up for a reduced investment return. Well, that’s it for now but join us next week as we explore some more of these congnitive biases.
Thank you again for listening to Simple Money Podcast. If you have any questions you can email me at firstname.lastname@example.org or find me on Twitter at F_FCOACH