Poor decisions are regrettable, but research suggests they may be, to a certain extent, preventable. Did you know your brain trains itself to take mental shortcuts? Psychology has branded these shortcuts as “heuristics,” and according to this article, they help your brain “conserve energy and work more efficiently” when making decisions. The problem is that these shortcuts sometimes fail to produce optimal results. Brains have a tendency to take all the bait thrown at them, and thus create these lazy heuristics, sometimes labeled as biases.
Business Insider created this infographic that highlights humanity’s most common mental incompetencies:
Upon viewing the infographic, I immediately recognized my own vulnerability to confirmation-bias. As a start-up founder, I have a strong view about the direction in which the wealth management industry is heading. (If I didn’t, I would still be in my comfy role at JP Morgan Asset Management.) Because I have a strong view on the topic, subconsciously I tend to read articles and facts that support my view of the world. In order to combat this bias, I make a conscious effort once a quarter to seek out fact-based counter-arguments and data to keep me honest. I learned this from my investor days at JP Morgan where it was VERY easy to fall into this bias that investor consensus tends to herd all the time.
To illustrate just how prolific these biases are in our own lives, we’ve highlighted 4 that we could relate to in a big way!
1. Outcome bias
Ah, yes. This is perhaps the most frustrating bias that we often, and easily, recognize in someone else. You know that guy who brags about his decisions when in reality he repeatedly made terrible choices that somehow seemed to work out fine? He’s dealing with a wicked case of outcome bias. Even when we know a decision is unwise, we may opt to do it if we’ve had a positive outcome from the same foolishness in the past. Speeding tickets are often directly linked to outcome bias. If you speed off one day trying to make it on time to dinner after a late meeting and don’t end up getting pulled over, you’re under the impression that the outcome (not getting a ticket) is something you can replicate. So you drive over the speed limit more often because you were able to drive fast and faced no ramifications for it in the past.
Outcome bias is seen fairly often in investing as well. Do you know that person? The one that randomly bought Domino’s Pizza stock 10 years back because they really liked eating cheese sticks there and then the stock returns over +1000%. Although there was no investment process followed in selecting the stock, the outcome made the person believe they are a terrific stock picker. Sadly, I have witnessed outcome bias all too often not only with fair weather investors but with many financial advisors or institutional portfolio managers.
Contrary to instinct, overconfidence isn’t a mental bias that only boisterous, bossy people are prone to suffer. The reality is that this bias can be the most difficult to overcome because few people want to believe that they could be excessively confident in themselves. No one wants to recognize that they have arrogant tendencies in their decision making. Hypothetical Susan may be the sweetest lady around, but her dual degree in World History and Cultural Studies may not serve her well when she’s selected to be on “Jeopardy!”, simply because her expertise will inflate her confidence so that she tends to take bigger risks than her opponent, layman Farmer Joe.
3. Confirmation bias
We’re all familiar with the quip “you only hear what you want to hear!”. Turns out, that it’s true. Research suggests that people have a tendency to only “hear” information that supports their own viewpoint. Or rather, when making a decision, the brain has a tendency to only consider the information in support of the decision that they find preferable. If you’re deciding whether to buy the $45,000 minivan or the $99,000+ Range Rover to haul around your family, but you really WANT the Range Rover, you’ll likely minimize the cost difference and oodles of cargo space in the minivan. Instead, you’ll focus on the Range Rover’s superior appearance, superb off-road capabilities, and note that the difference in fuel mileage is surprisingly negligible. Before you know it, you’ll be driving one off the lot!
4. Bandwagon Effect
Everyone experienced this in middle school to a certain degree. When people do something primarily because other people are doing it, regardless of their own beliefs, which they may ignore or override. The bandwagon effect is very common in the investing world. If every investor you know owns Tesla stock and they brag about the stock performance at every social event, it makes it harder and harder not to buy it, despite the fact that you think the stock isn’t a great investment at current valuations. The bandwagon effect is a big reason why the markets still see episodes like the Tech Bubble in the late 1990s and the Crypto Bubble of 2017 despite having access to more facts and information than any previous generations.
How does this affect our personal finances?
People fall prey to these shortcomings of their minds every day in myriads of ways, including financial decision making. Some of these biases can create financial neurosis – a term that explains the phenomenon of spending habits that line up with your prior situations, not your current one. A person dealing with financial neurosis continues to make financial decisions based on circumstances grounded in an earlier stage of life. For example, when someone has a baby everything changes. Oftentimes our financial spending, time management, and recreation don’t adjust instantaneously!
Another example can be found in the transition from college life to working full time. Many college students are only worried about paying their expenses and passing their classes, not saving (and certainly not investing). Even when you start that new job after college, student loans and other regular monthly expenses hog up your money and financial game plan. Climb the proverbial career ladder and you’ll find your monthly income increasing, but are your habits changing too? Are you still living month to month?
The good news is that financial neurosis and other mental shortcuts can be overcome. Awareness is key. Just by reading this article you’ve taken the first step towards training your brain to be more comprehensive in its decision making. Be willing to recognize decisions that weren’t the best, and be willing to admit that your brain has biases just like everyone else. The ramifications of your reflection will positively impact your ability to engage in decision making; that’s good news for you and your finances!