Early theories of individual and group economic behavior were based on the idealistic notion that people make rational financial decisions that are always in their own best interest.
Behavioral economics, on the other hand, examines more broadly how cognitive, social, and emotional factors influence our decisions about money and subsequent financial behaviors. As a field of study, it began to garner interest in the 1970s, with the publication of two papers by Daniel Kahneman and Amos Tversky. These combined cognitive psychology with classic economic analysis to explain the often foolish decisions people can make when evaluating financial choices. Since then, their ideas have entered popular culture, together with several specific ways that people often think less than rationally about money and finances, known as cognitive biases. Some common cognitive biases in financial decision making include discounting the future, overconfidence, anchoring, confirmation bias, and loss aversion.
Discounting the future
This cognitive bias refers to the tendency we all have to give more importance to needs and wants in the present over those in the distant future. Discounting the future happens to most of us because the present is concrete and immediate, demanding our attention and resources, while the future is abstract and ‘someday’, making it much easier to put off until later. Discounting the future can lead to overspending and taking on too much debt, or not saving enough for retirement.
Another bias is overconfidence, or being excessively optimistic and downplaying the possibility of negative events that could happen. While there are always some people who are overly pessimistic within the general population, more people lean towards overconfidence. Consider previous stock market bubbles, when people believed that their already overvalued dot.com stocks could only go up, forever. Or the person who doesn’t buy insurance because they’ll never have an accident.
Anchoring refers to our tendency to use the first number or other piece of information we encounter as our baseline for comparison. At a restaurant, we see a filet mignon on the menu and think $53 is more than we want to spend on an entree. But the $31 ribeye steak suddenly seems reasonable. Salespeople often use anchoring by showing a buyer the most expensive, top of the line item first, then the cheapest, poorest quality model, ending with a successful sale of the middle of the range option. And of course, anchoring often figures prominently in salary negotiations. Anchoring bias can lead to overpaying, and is difficult to resist.
Confirmation bias is the tendency to give more weight to new information or an opinion that confirms what we already believe to be true, and to ignore contradictory evidence. Confirmation bias makes us disregard new information that conflicts with our existing belief, and is one of the reasons why stock market bulls tend to stay bullish while bears remain bearish, which can influence irrational stock market behaviors as a whole. It is also leads us to value what we already have more highly, compared to how a stranger or outsider would rate it.
Kahneman and Tversky were the first to identify and quantify the phenomena of loss aversion—our propensity to feel regret over a financial loss more acutely than pleasure at a gain of the same amount. In other words, we feel better when we avoid losing $100 than when we find a $100 windfall. Another example of loss aversion in action is when marketers use a free trial period to induce the fear of having something taken away in prospective buyers. The perception of potential loss can also be influenced by cognitive framing, that is, how the information is presented. Which would you choose: getting a $20 rebate, or avoiding a $20 fee? The amount of money is the same in either case, but most people prefer avoiding the fee to getting the rebate. Loss aversion explains why people sometimes sell a conservative stock with solid earnings out of panic when the market as a whole drops. It can lead to people not investing in the stock market at all, resulting in their retirement savings being eroded by rising inflation.
Simply being aware of cognitive biases doesn’t always translate into immunity from them, as Richard Thaler previously noted. While cognitive biases result in irrational thinking, they are rooted in our most basic emotions and instincts—which is why they are so difficult to overcome. Even financial professionals are not immune. Some observers believe that a combination of investment bankers’ overconfidence and confirmation bias led directly to the subprime mortgage meltdown that precipitated the 2008 financial crisis. These biases help explain why education alone is usually not enough to change behavior. In Part 4, I’ll reveal what it takes to actually change people’s behavior in the real world.
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