Do you ever look back at some of the financial decisions you’ve made and wonder what you were thinking? If so, trust us, you're not alone. According to behavioral economics research, many of our money choices can be attributed to cognitive biases. The funny thing about these biases is that most of the time we aren’t even aware of them or their influence on our thinking. If we educate ourselves about them, however, then we’ll potentially stand a better chance at identifying and overcoming them in the future so we make wiser financial decisions. In this article, we'll take an in-depth look at five different cognitive biases and how they can potentially lead to unwise investment or spending decisions.
Confirmation bias refers to the tendency to seek out information that confirms one’s existing beliefs. We often see this cognitive bias when it comes to politics; people gravitate toward facts and opinions that support their existing political views. Similarly, this bias can cause an individual to make unwise financial decisions if they only look for information that supports their investment thesis and ignore anything that contradicts it.
When one relies most heavily on the first piece of information they encounter to make a decision, they succumb to the anchoring effect. This cognitive bias can lead an investor astray if they place too much importance on the initial price of an investment, for instance, and fail to consider other relevant factors.
You’re likely aware of the term herd mentality (maybe it makes you think of sheep!) In simple terms, herding is the tendency to follow the crowd. This was problematic for us in middle school and can also be a problem financially as an adult if we choose to blindly follow the recommendations of others without doing our own research.
When one is excessively confident – also known as the overconfidence bias – they might overestimate their ability to pick winning investments or underestimate the risks involved. If someone mistakenly believes they understand the markets and certain investments more than they actually do, they’ll be more apt to ignore the advice of experts and make errors that might be detrimental to their financial well-being.
Sunk Cost Effect
The sunk cost fallacy occurs when one continues to invest in a losing proposition in hopes of recouping their losses, rather than cutting them and moving on. This bias can lead to unwise financial decision-making when an investor hangs on to a losing investment for too long, rather than selling it and reinvesting the proceeds in a more promising opportunity.
Our propensity for cognitive biases unfortunately leaves us all potentially vulnerable to a range of financial mistakes. To combat this, it’s important to remain mindful of psychological tendencies, including confirmation bias, anchoring, herd mentality, overconfidence bias, and sunk cost effect. It’s a good idea to take a step back before any major financial decisions and consider if any biases could possibly be affecting your judgment in an unhelpful way. It can be hard work at times, but being aware of cognitive pitfalls is an essential part of knowing yourself and growing as an investor. Armed with this knowledge, you can potentially make better financial decisions that will hopefully benefit you in the long run.