Human beings are intelligent people, capable of making good decisions, weighing all options and making a rational and well thought out conclusion. However, sometimes it feels like we act irrationally without even realizing we are doing it. In some cases, our brains are hard wired or pre-dispositioned to behave in a certain way if our conscious mind does not take over and think rationally.
Luckily, because of our conscious mind, we can override our natural evolutionary desire to act irrationally in certain instances. Here are 5 biases and fallacies that make us terrible with money and how we can overcome them.
- Recency bias
Recency bias occurs when we base on current or future behavior or outcome on what has happened in the recent past. Put differently, whatever is happening now, will also happen tomorrow and the day after. Recency bias occurs because of our flawed and selective memory. Most people’s memories are not as good as they think and much of what we do remember may be distorted based on what we focused on and our emotions at the time.
Common examples of recency bias include: house prices have been going up each month for the past 2 years, so they are bound to continue going up. This stock/mutual fund has reported a gain each day this quarter, so it must be a promising investment. I have kept a steady full time job with the same company for the last 3 years; therefore I don’t anticipate this will change in the future.
Why It Is Dangerous
Recency bias is dangerous because it assumes future investment performance is based on past performance and puts a disproportionate amount of weight on this assumption. Some ways of you can minimize recency bias include:
- Increase the timeline used to assess financial information. History is never an indicator of future outcome, but the further back in history you go to understand a topic the more you will be able to see trends and patterns of history. Trends and patterns offer better information than a few years or months of information.
- Speak to someone with an opposing view and get their perspective. The recency bias can cause us to be closed minded to other possibilities and outcomes. Talking to someone with an opposing view can give us perspective. For example: if you are basing a decision on the fact that prices will go up, talk to someone that believes they will go down. Keep an open mind, but also insist in credible data to be used when disputing both sides. This experience may either strengthen your stance further or at a minimum, widen your perspective.
- Sunk cost fallacy
Sunk cost is any cost that has been paid already and can never be recovered, no matter what the future outcome or business decision. It is a past cost that is not affected by a future decision. Sunk cost can also be the loss of time or non-monetary resources. The point is that they are not and will never be recoverable. Examples of sunk cost include: you paid $500 to get your 15 year old car fixed last week. Two weeks later, you discovered another problem that will cost you $2,000, but you have already decided last week to keep the car. The $500 would be considered a sunk cost whether you actually decide to go with your original decision to keep the car or decide to get rid of it. Another way example would be overeating at a buffet in order to get your ‘money’s worth’. Regardless of how much you eat, will not change the outcome of how much you pay.
How to Overcome Sunk Costs
Overcoming the sunk cost fallacy can be difficult because we place more pain in our losses than we do pleasures in our wins. This can cause use to continue make even more bad decisions in hopes of recouping our losses. Continually putting money into a dying business or investment is another example of the sunk cost fallacy. Here are a few tips to overcoming the sunk cost fallacy:
- Know in advance a dollar amount or percentage you are willing to lose before you decide to get out. Having a floor value helps to minimize the emotion around this fallacy that can result in dumping more money into a bad decision. For example: if this investment drops more than 10%, I will sell my holdings and walk away. If this business produces a loss for more than 3 years, I will cut my losses and close the business.
- Give yourself the opportunity to fail, but also provide yourself with an out. Put differently, never put all your eggs in one basket. Making mistakes is a part of life, but when it comes to financial decisions, diversification in your investments can help minimize the impact of this fallacy.
- Gambler’s fallacy
The gambler’s fallacy is the mistaken belief that if something happens more frequent than normal during a period, it will happen less frequently in the future. Gambler’s fallacy is opposite to the recency bias. If things are going too good, surely they are bound to go bad soon. Alternatively, if things are going poorly, surely they are bound to turn around soon. Gambler’s fallacy is what keeps people continually losing money in the slot machines or buying lottery tickets, because surely there can only be so much bad luck that at some point, good luck will come.
Why Is It Dangerous
Gambler’s fallacy is dangerous because it gives little regard to probability or distorts how probability works in the mind of the person that is hoping for the desired outcome. For example, when you flip a coin, there is a 50/50 chance it will be heads or tails. If you flipped the coin 7 times and it always came up as heads, the 8th flip would still have a 50/50 chance of showing heads or tails. Assuming this probability would be skewed towards tails would be incorrect; the probability would still be 50/50.
Some ways to reduce gambler’s fallacy include:
- Avoid financial decisions that rely entirely on probability. For example: gambling, buying lottery tickets etc. In many instances, these probabilities are stacked against you.
- If probability is all you have to go by, make sure the probability is stacked in your favor. This doesn’t remove the possibility of incurring a loss, but it does hedge some risk.
- Buyer’s remorse
Buyer’s remorse is the sense of regret after having made a purchase. It is frequently associated with making an expensive purchase. It may stem from fear of making the wrong choice, guilt over extravagance, or a suspicion of having been overly influenced by the seller. We have all experienced buyer’s remorse at some point in our lives and it is not a good feeling. Some practical ways to avoid buyer’s remorse include:
- Implementing a waiting period. Set a waiting period for the purchase of items over a certain dollar amount. Typically, we get buyer’s remorse over more expensive purchases. However, expensive can mean different things to different people. Figure out what your dollar threshold is and the length of time you are willing to wait before making a purchase. Typically you want to wait at least 48 hours (2 days) or more for major purchases. Waiting to make the purchase allows you to think more carefully about the decision. It also removes the opportunity of making a purchase based on feelings as our feelings are always changing and never constant.
- Know the return/exchange policy before you buy. Even if you have no intention of returning the product, it is important to understand what the companies return policy is. What if you purchased the item but it did not work as you would have hoped? What if you found a better priced alternative? Make sure you know what type of exit strategy you have available to you (if any) and how much time you have available to act.
- Check your budget and assess the timing. You may have implemented a waiting period and even been comfortable with the return policy, but if the budget does not allow the purchase then you may still find yourself with buyer’s remorse. Make sure you are not financial strain after making the purchase. Review your budget to know what you can realistically afford.
- Confirmation bias
Confirmation bias occurs when we favor information which confirms our pre-existing beliefs and biases. Confirmation bias narrows our understanding and perspective because we fail to read, listen to or understand differing views. Examples of confirmation bias include: watching a particular news channel that only align with your political views. Reading financial information from bloggers or companies that agree with our views on spending, saving and investing.
Confirmation bias is not inherently bad, but reading and listening to information that we already agree with does not increase our learning or expand our perspective. Ways to reduce confirmation bias include:
- Consciously making an effort to read or listen to other people’s views even if we do not agree with them
- Understanding the perspectives of both sides before making a decision
- Putting you in the other person’s shoes and looking at things from their perspective.