There’s a fascinating link between psychology and money that tries to explain how we think and behave when it comes to saving, spending, and investing. It was Meir Statman’s book, What Investors Really Want, that first opened my eyes to behavioural biases and how to make smarter financial decisions.
“It’s not that we’re dumb. We’re wired to avoid pain and pursue pleasure and security. It feels right to sell when everyone around us is scared and buy when everyone feels great. It may feel right-but it’s not rational.”
The book examines heuristics and biases that affect our decisions, such as anchoring, which is a tendency to be influenced by irrelevant numbers. For example, if a stock is trading above $50 it might be deemed “expensive” but a closer look at its fundamentals might reveal that price to be a bargain.
Another example is the availability heuristic, which occurs when people make judgments about the probability of events based on how easy it is to think of examples. The financial crisis of 2008 is still fresh in the minds of investors and many believe that “we’re due” for another crash of that magnitude. In reality, stocks falling by 50% or more again is an extremely low probability event.
A Big List of Behavioural Biases
I came across a big list of behavioural biases on The Psy-Fi Blog and I wanted to share some of the ones that resonated with me the most:
Ambiguity Aversion: we don’t mind risk but we hate uncertainty.
Bird in the Hand Fallacy: the idea that dividends now are more certain than capital gains later, therefore dividends are more important than capital gains.
Confirmation Bias: we interpret evidence to support our prior beliefs and, if all else fails, we ignore evidence that contradicts it.
Endowment Effect: people value stuff more because they own it.
Gambler’s Fallacy: the mistaken belief that a run of specific results in a random process must revert.
Hindsight Bias: we’re unable to stop ourselves thinking we predicted events, even though we’re woefully bad at predicting the future.
Home Bias: investors prefer to invest in their own, local markets, rather than seeking wider diversification.
Mental Accounting: we divide our money into different pots and then treat them all separately.
Myopic Loss Aversion: the tendency to check your portfolio every five minutes, and sell as soon as you think you might lose money.
Overconfidence: we’re way too confident in our abilities, which seems to be an in-built bias that we’re unable to overcome without excessive effort.
Risk Aversion: people prefer certain outcomes to uncertain ones, even when the returns on the latter are expected to be better.
Sunk Cost Fallacy: future investment is justified because lots of prior investment has occurred.
Zero-risk bias: we often prefer the total elimination of minor risks to the significant reduction of large ones
Kahneman describes our thought process in two different ways. The first is system 1, the fast, instinctive, and emotional thinking that we use most often. The second is system 2, the slower, deliberate, and more logical way of thinking that requires real effort.
A good example he used is to imagine yourself driving on the highway with barely any traffic around you and you’re having a conversation with the passengers in the car. System 1 is at work. Now you find yourself behind a slower moving semi-truck that you wish to pass. Suddenly, as you pull out into the other lane, both hands are on the wheel and the conversation stops – you don’t want any distractions while you concentrate on making the pass. That’s system 2.
The key is knowing when and in what situations you should slow down and let system 2 take over. A better understanding of behavioural biases might not always prevent a lapse in judgement, but it can lead to smarter decisions, especially when it comes to your finances.