Challenging our financial biases can help us choose more wisely
We all have cognitive biases, but understanding the most common ones can help us make better decisions. (iStock)
Life is an endless stream of decisions—an estimated 35,000 of them every day. Most are pretty much unconscious. But even those we think are careful and deliberate can be unconsciously shaped by “cognitive biases”—those decision-making short cuts our brains use to simplify information processing.
Most of the time these shortcuts are effective in helping us navigate daily life, but sometimes they undermine thoughtful decision making.
The list of cognitive biases is long and growing, but here are the top five most likely to affect financial decisions.
- Confirmation Bias: Where we look for and value information that confirms what we already believe. This can cause us to overlook potential risks and ignore warning signs.
- Loss Aversion: Losing hurts more than gaining feels good. This simple truth can lead us to hold on to losing investments hoping for recovery rather than cutting our losses.
- Herd Mentality: Causes us to follow other people’s decisions, trusting they know something we don’t. Meme stocks, anyone?
- Endowment Effect: Pushes people to overvalue items they own compared to identical items they don’t own. This can make it difficult for us to part with an investment, even when it doesn’t meet our financial goals.
- Recency Bias: Leads us to disproportionately emphasize the most recent events and our most recent experiences. This forces us to rely too heavily on the most recent market trends without considering long-term historical data.
Recognizing our own cognitive biases can require brutal honesty. It can also help us improve our decision making and get ahead financially.
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