Have you ever noticed your tendency to want to stick with a failing project "just a little longer" with hopes that it will pan out? Or maybe, when faced with a loss, your immediate tendency to blame a particular moment or decision, touting, "I should have known."
Perhaps to your surprise, these are called biases, and they have the power to impact your investment decisions and financial plans beyond what you may initially realize. Biases can hold you back from making important decisions, allow you to stay in a bad situation longer, and even cause you to avoid exploring potentially excellent agreements, investments, and relationships.
Of course, you're probably like me in that when I first heard about biases, I thought none of them applied to me - surely, I'd just be learning what biases everyone else has! To my surprise, a single class on biases opened my eyes to the fact that I have personally experienced every single one of them!
Before taking this class, I had no idea that there were so many biases, much less that they had such an impact on my own behavior. Acknowledging and understanding some of these has helped me make more informed decisions and I believe that highlighting the top few here can also help you.
How Many Types of Biases Are There?
There are more than 175 different types of bias, but there are many factors involved, and some happen more frequently than others. Some are social while others affect your memory, beliefs, behavior, and decision-making.
Here are some that can directly affect your financial decisions:
Confirmation bias is the act of screening what you hear against your own preexisting personal beliefs about what is true. When you hear someone talking and agree with what they're saying, you automatically assume they're right. You've already aligned your own beliefs with theirs. You immediately think they're smart.
But what about the person who is talking about the same subject but has a different viewpoint? Your inherent confirmation bias might automatically make you think they're wrong, misinformed, or perhaps that they're generating arguments intentionally.
There's nothing wrong with confirmation biases, but always making investment decisions based on your own beliefs can be detrimental to your financial future. When your financial decision-making only takes into account information that supports your previously-held thoughts and assumptions, you're less likely to seek information. or perform research.
So how does this affect your financial well-being? When you surround yourself with like-minded people and you're faced with challenging financial decisions, you're limiting your options - everyone is going to agree with you and offer similar advice, "proving" your ideas true.
The smaller your circle, the more likely the people in it will reflect critical thinking processes very similar to your own. This results in less curiosity on your part and a vastly reduced possibility that you'll explore opposite opinions seek potentially opposing advice, or open your mind to new evidence to support those different opinions.
By having a well-rounded, respected group with individual differences, your financial decisions can be planned with expanded knowledge, alternatives, and strategies that you never would have considered otherwise. This wide array of opinions expands your existing beliefs and gives you the desire to research, learn, and grow beyond your own confirmation bias.
There was a study conducted that tracked success and longevity in retirement. A group of people was monitored in terms of their happiness, their health, and their life expectancy. The study concluded that people who engaged in conversations with others with a different viewpoint led longer, healthier, happier lives.
How can you use this confirmation bias to your advantage? The next time you have a conversation with someone who you know has a different viewpoint, be open to understanding why they think that way. Use your knowledge of confirmation bias to ask questions. It doesn't mean you have to change your mind, and it doesn't mean you have to try to convince them to take your side.
You will benefit from your curiosity, and recognizing that confirmation bias tends to narrow our viewpoint instead of expanding it.
Loss Aversion Bias
Aversion bias refers to the fact that you are disproportionately more upset by a loss than you enjoy your gains. In other words, you're more disappointed when you lose something than you are about gaining something.
Example 1: You're walking through a parking lot, and find a $10 bill. You feel happy about that, and it boosts your mood. Then you realize that you lost that $10 bill. You feel upset, mad, and perhaps even feel like a failure. You focus much more on the fact that it's gone, rather than the realization that it's the same $10 bill you just found fifteen minutes earlier. You have a bigger reaction when you lose money than when you make money.
How does loss aversion affect your financial decisions and investment plans? There are two main ways this shows up for investors:
The first is how you react when the stock market is down. You've probably noticed the decline in the stock market over the last few months. No one is happy about that. No one wants to see their statements reflect a lower balance. Even though, in the back of your mind, you know that all investment decisions pose a risk of potential losses, negative outcomes influence your reactions more.
Your mind tends to forget that the previous two years held some of the biggest profits ever recorded because all you can see is the loss today.
Example 2: Two years ago, your investment portfolio was worth $500,000. Yesterday it was worth $540,000. By looking at just these two figures, you should be happy that your investments grew by 8%, even during a global pandemic.
But you're not happy, because six months ago your portfolio was worth $600,000, so now you're focused on the $60,000 that was lost instead of the $40,000 profit.
There are financial computer models that predict real-world financial decision-making in humans. The research shows that investors tend to sell low and buy high - the opposite of what every investor attempts to do.
When there is an upswing in stocks, many investors quickly start buying more, and the company sells more. This spike in supply causes the market to decline, and the (demand) value of the stock goes down. As the market goes down, investors panic and sell their shares for a portion of the cost they bought them for. Then the market bottoms out, begins to stabilize and starts to come back.
The second way loss aversion affects your financial decisions involves avoiding taxes, meaning even if an investment opportunity makes a considerable profit, you'd rather not invest at all because you don't want to pay taxes when you sell.
Example 3: At present, you have an investment that has gained $100,000 since you've owned it. Hypothetically, tax costs would be $20,000 when you sold. You decide not to sell because you don't want to "lose" the profits. You have completely forgotten that you still gained $80,000. This part of loss aversion tends to prevent people from having confidence in their financial decisions. It creates false beliefs that you are losing money.
Sunk Cost Bias
Sunk cost bias is the fear of losing the time, energy, and money we've invested in working on something. It is hard to cut ties with a team, project, or organization when we know how much we have already invested, even when it's not producing the results we want.
This is similar to loss aversion bias because we don't want to lose money and time. However, the difference is that we stubbornly manage to prolong our commitment, sometimes setting our budgeting process and financial plans aside in an attempt to salvage the effort we've already contributed to the project.
Sunk cost comes into play in all types of business and financial decisions. Once the time or money is already spent, it's a sunk cost. There is no real way to get that money back, even though we tend to believe that if a project becomes profitable, we'll "earn our money back."
We assume that quitting would mean an instant loss of effort and money instead of considering that pursuing the goal further, otherwise known as digging our heels in, might result in a loss of even more time and money. Sometimes it is best to "cut your losses" and drop a project or sell an investment, even after you've made a large investment.
When it comes to investing, we often make the financial decision to hold onto an investment at a loss because: we hope it'll bounce back, and we consider its initial cost factor. Loss aversion biases make cost a factor, no matter the current market value, whether it's the stock market, an investment, or real estate.
Sunk cost bias also affects our relationships with employees and in our business ventures. Anything that we've invested time, energy, and money into is difficult to let go of.
Example 4: You're a business owner, and need to outsource a project that isn't something you are well versed in. You choose a more expensive firm, thinking that the higher fee will provide you with a better outcome.
Over the course of several months, things start to fall apart. Your expectations aren't being met, and you have to decide whether to cut ties with this company, knowing you won't get your time or money back.
Holding onto that sunk cost bias, you prolong the decision for several more months, hoping that things will straighten themselves out. It doesn't work out, and you finally cut ties with the business. Sometimes these natural biases can make key financial decisions like this one become clouded with feelings of failure and self-blame.
Omission bias is the tendency to do nothing about the situation- you prefer to do nothing rather than do something that could potentially make things worse. Think of this as part of your brain's fight, flight, or freeze mechanism.
You've heard people mention how much they can't stand their job, or how much they dislike their coworkers or boss. Why don't they quit and change jobs? Why do they stay even though they're miserable? Generally, it's because people tend to shy away from change.
Making a big change requires important decision-making skills, financial planning, and habit adjustment. Most people would rather suffer in a situation they don't like than put forth the effort required to initiate change. Omission bias is also common when it comes to dealing with inheritance as part of a loss of a loved one.
When it comes to finance and investments, people want to make good decisions, but they have the tendency to freeze, because they're afraid of making a mistake. The truth is, sometimes the cost of doing nothing is actually higher than the potential mistake.
The most important thing to remember is to have compassion for yourself, and confidence that you're going to make the best financial decision based on the information you have at the moment. If things don't turn out like you hoped, feel good about the fact that you took action instead of doing nothing.
Example 5: You're driving in an unfamiliar city and are using GPS to find an address for a potential client. You take a wrong turn, and your GPS starts to recalculate your route. Just because you've turned down the wrong street doesn't mean you're going to pull over and just stop driving. You'll try another route, or turn around.
If you feel overwhelmed by something, and aren't sure what to do, you might fall into this bias and freeze. Hopefully, by having the knowledge of omission bias, you can navigate through your situation with an understanding that sometimes doing nothing is the best thing to do. Just ensure that you're not using it as a excuse.
Hindsight Bias is the tendency to judge outcomes that go wrong by blaming yourself for a poor decision - thinking you should have seen it coming, or believing that all you do is make bad choices. This is all too common when it comes to online scams.
In any experience, you can typically trace your footsteps backward to a choice or crossroads that eventually led you here. When you're staring at a currently poor outcome, it can seem natural to look back at the most recent choices you made and begin to get down on yourself. By telling yourself you're always wrong, that you're dumb, or any number of personal insults, you lose your confidence.
This happens with investment decisions as well. Perhaps you look over your portfolio, and see that one of your investments is way down, or one of your stocks isn't performing well. That may lead you to believe you made a mistake and that you should've sold it months ago.
Your brain is playing tricks on you. Recognize that this is hindsight bias as soon as possible and stop engaging with that negative judgment of yourself. Try to think about the situation in a different way and let it be an education instead. It's highly likely that every decision you make is with the intention of making the best choice possible with the information you have at hand. When something goes wrong, try to learn from the experience and then let it go.
Don't start agonizing over past decisions. It's a waste of your time and energy. What's done is done. It's not going to change the outcome.
Did You Recognize Yourself in Any of These Biases?
As you've gone through each of these descriptions, how many of them sound familiar to you? Some or all may resonate with you, and that's okay!
As I shared at the beginning of this article, I didn't expect to resonate so deeply with each type of bias, but I did see myself and some of my own personal decision-making affected by each one.
Knowing that you are prone to certain biases is a great learning and awareness exercise. By identifying them within yourself, you can allow this new knowledge on biases to help minimize their impact on your life.
Your increased awareness of your internal, very natural biases is a great reason to invite 3rd party professionals like consultants and advisors into your life anytime you're considering big changes. My own personal and business coaches, therapists, consultants, and advisors have been internal to moving forward with a positive mindset.
You are amazing, exactly the way you are. No one is perfect. When you discover something isn't going as planned, just use your own internal GPS to redirect you toward a different and better outcome and keep going.