Introduction
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 interests. Behavioral economics, on the other hand, examines more broadly how cognitive, social, and emotional factors influence our decisions about money and financial behaviors. As a field of study, it began to take the stage in the 1970s, with the publication of two papers by Daniel Kahneman and Amos Tversky that combined cognitive psychology with classic economic analysis to explain the imprudent decisions people often make when evaluating financial choices. Since then, their ideas have entered popular culture, together with the specific ways in which people think irrationally about money and finances—predictably, as Dr. Dan Ariely discusses in his book Predictably Irrational. 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, because the present is concrete and immediate while the future is abstract and ‘someday’. Discounting the future can lead to overspending and taking on too much debt, or not saving enough for retirement. One way to resist this tendency is to vividly imagine an ideal future, then create a physical representation of it by making a collage or writing and drawing a story of what that would look like, in as much detail as possible. Then, the recommendation is to start creating an action plan, based on what realistically can or may happen to make that ideal future possible.
Overconfidence
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. Think about 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. Overcoming overconfidence can be accomplished by looking realistically at what could go wrong, and thinking about how to mitigate potential risks.
Anchoring
Anchoring refers to the propensity to use the first number encountered as a baseline for comparison. At a restaurant, we see a filet mignon on the menu and think that $53 is more than we want to spend on an entree. But the $31 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, and ending with the middle of the range option. The last middle of the range option will always be the most emotionally appealing, based on anchoring. Anchoring bias is difficult to resist. One method that has been demonstrated to be effective is to write down reasons why a particular anchor is inappropriate. This further clarifies the situation and makes both strategic and rational decisions more obvious.
Confirmation Bias
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. Resist the tendency towards confirmation bias by seeking out opposing opinions and weighing all the evidence dispassionately.
Loss Aversion
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 their stocks out of panic when the market drops, and can lead to people not investing in the stock market at all, resulting in their retirement savings being eroded by rising inflation.
Conclusion
Being aware of these biases doesn’t always translate into immunity from them—but it can help. While cognitive biases result in irrational thinking, they are rooted in our most basic emotions—which is why they are so difficult to overcome. Even financial professionals are not immune. These biases also help explain why education alone is usually not enough to change behavior. It’s important to be as aware and as rational as possible when making financial plans and decisions. Often times, the easiest way to do that is to consult a neutral third party such as a financial coach, mentor, or advisor. In doing our best to remove the biases that typically play a larger role than we are willing to admit, people can see situations more clearly and make thoughtful, grounded decisions accordingly.