Human emotions play a large part in our financial decisions. Dr. Daniel Kahneman, a Nobel Prize winner in 2002 for economics, used a framework of “two minds” to describe how people make decisions (Benartzi, 2012). We make intuitive decisions – rapid judgments which we tend to generally accept as valid (and they are usually correct). We also make reflective decisions – slow, analytical conclusions that often require conscious effort.
The problem is that traditional finance says that humans are rational creatures, are very self-interested, and will always make the right choice when given enough information. Fortunately, we humans are not always self-interested; instead we do tend to care for other people. Unfortunately, though, we do not always make rational decisions as we are not as disciplined as we would like to be. This is due to the fact that we are biased in our decision-making ability because of mental shortcuts that we take known as heuristics.
The following are explanations of a few (and there are many more) important behavioral biases that people should be aware of as they may be negatively impacting your ability to increase your financial position. Yet, these biases should also be understood by financial planners so that they may be able to help their clients overcome them and lead to further positive change in their client’s lives.
Loss Aversion – This is where people feel losses much more strongly than they do gains. It was developed by Daniel Kahneman and Amos Tversky in 1979, and much research on this bias has found that losses are twice as powerful as the possibility for making a gain (Pompian, 2012). Loss aversion really takes a toll with respect to one’s investments as people tend to hold on to underperforming securities too long as they remain hopeful that it will “break-even” while also selling investments too soon that have gained. This creates a viscous cycle that will impact your financial portfolio over time.
Confirmation bias –This occurs when an individual only listens to and selects ideas, news, tv, or anything else that confirms their own belief. They then completely devalue whatever may contradict their belief, even if the contradictory belief has been proven to be better than what the individual currently holds on to. We attach an emphasis to the outcomes we desire. An example would be putting too much into the stock of the company you work for (which also reduces your diversification!). The best way to overcome this bias is to consider information from multiple sources.
Illusion of control bias – When someone believes they can exert more control over their environment than what they actually can control, they are under the influence of this bias. This bias is very prevalent in the gambling and investing arenas. Can we really control what the outcomes of the slot machine are? What about how the stock market does? Not really. Instead, we need to focus on the things we can control such as our savings and spending habits, the amount of insurance coverage we have, and whether or not we have an estate plan.
Hindsight bias – This occurs when people believe that the event was predictable when, in reality, it was not. We tend to overestimate the accuracy of our predictions (impact of future forecasting). Pompian states the following “hindsight bias’s biggest implication for investors is that it gives investors a false sense of security when making investment decisions. This can manifest itself in excessive risk-taking behavior and place people’s portfolios at risk.” Many investors subject to this bias place undue blame towards their financial planners for not realizing the inevitable negative event that occurred. Yet, in good times they may praise their financial planners for “good performance” – which ties to the above-mentioned bias of illusion of control – can we really control the markets? No.
Herd Mentality – Occurs when individuals are influenced by their peers to follow trends, purchase items, and adopt certain behaviors, even if it is not in their best interest. Stopping to ask yourself why you are making this financial decision, and looking to see if it aligns with your financial plan, will go a long way in helping ensure that the actions you are taking are actually right for you, not for someone else. Warren Buffett tends to be contrarian and do the opposite of what the “herd” does. He famously said, “Be greedy when others are fearful, and be fearful when others are greedy” (“Investing Experts”, n.d., p. 1).
Having an understanding of behavioral biases and knowing how they may be impacting your personal finances may help you overcome the biases, or at least minimalize the impact the biases may have. Have you considered your biases and discussed them with your financial planner?
Benartzi, S., (2012). Behavioral finance in action: Part 1. Obtained from: http://befi.allianzgi.com/en/Publications/Documents/Part%201-Introduction%20and%20Two%20Minds.pdf
Pompian, M. (2012). Behavioral finance and wealth management (2nd ed.). Hoboken, NJ: Wiley Finance.
Investing experts and the herd mentality. (n.d.). Retrieved from http://thefirstmillionisthehardest.net/investing-experts-herd-mentality/