Cognitive biases are essentially predictable ways that our brains fool us. When we fall into these thinking traps, we allow ourselves to be hijacked by essentially emotion disguised as reason.
Loss Aversion
Loss Aversion refers to the fact that the pain of a loss is much deeper than the joy of a gain. We see this, for example, when we're investing. The pain of money that we've worked so hard to earn disappearing feels so much more emotionally resonant than the joy of seeing money that we haven't earned with our time, effort, or sweat magically appear or mysteriously appear through the magic of compounding growth. We might be prone to investing more conservatively than we actually need to, and the result of that may be that over the long term, we end up earning less through our investment portfolio than we otherwise could have. Or it might mean that when the market drops, like at the beginning of the pandemic, we panic and we sell, and we lock in those paper losses and turn those into real losses. That's how loss aversion can lead us astray.
Negativity Bias
Negativity Bias means that if something negative happens, we give it more weight than the positive things that have happened. And if you post something on Instagram, and ten of your friends say, "You look great," and then one person says, "Oh, you're an idiot, or you look ugly," you're gonna remember that one person more than you're gonna remember the other ten. If we have one bad experience with investing, then that can sour our feelings about investing. Maybe you have a bad experience owning a rental property. You have a nightmare tenant. It might not even have happened to you. Maybe it happened to your mom or dad, or to your cousin, to someone you know, but that one experience that happened to one person somewhere at some time has such a profound emotional impact that it knocks you out of the game, and you stay away from owning rental properties for years, for decades, maybe for your entire life. One experience can do that to you.
Overconfidence Bias
Overconfidence Bias is the bias in which we think that we're better at something than we actually are. For example, most people believe that they are above-average drivers, which is mathematically impossible. There's a well-documented effect called the Dunning-Kruger Effect, in which people who know the least about a topic believe that they know the most about it. They're operating at what's called the level of “unconscious incompetence,” meaning they don't know what they don't know. They underestimate the depth, the nuance of that field. By contrast, people who are actually experts in a given field are less confident than the people who know nothing because they know enough about that field to recognize how much they don't know. So let's link that to the world of investing. If you don't know a whole lot about stock investing, real estate investing, or cryptocurrency investing, then you might take some hot stock tip at the water cooler and it sounds good because you don't know enough to be able to exercise critical judgment about it. And you have that level of overconfidence that comes from ineptitude.
Anchoring Bias
Anchoring Bias happens when you see a given price point and that initial price point that you see then anchors in your mind as what that price point ought to be. And any comparison that you make is made based relative to that anchor. You'll see, for example, people say, "Oh, I used to be able to buy this particular house at 123 Main Street for $200,000, and today it's worth $300,000. And because there's such a difference between what my brain has anchored at and what it's worth today, I'm going to judge it based on its previous value." Now, the problem with that is that it can cause you to have a poor understanding of how things should be priced in the present. You pass up homes that are good deals, and you pass up stocks that are good deals because you're thinking about what Apple or Tesla used to be worth five years ago. You accept job opportunities that don't pay as well as they ought to because you're anchored to what you used to make five years ago versus what you really could command today. Anchoring bias skews what we think we can both command and spend.
Sunk Cost Fallacy
And our final example is something called Sunk Cost Fallacy. If I've invested a given amount of money or time into something, I don't want the emotional pain of feeling that that has gone to waste. Let's say that I've bought a stock and that stock goes down. Instead of reevaluating, "You know, was it a wise decision for me to buy that?", I might instead say, "All right, well I'm just gonna dollar-cost average all the way down," and then just start throwing good money after bad in the hopes that if I can continue to buy it on its way down, it'll eventually come back up. The reality is a given stock doesn't care what I bought it for, and just because it's gone down doesn't mean it's going to necessarily go back up. And the same thing happens with the way that we spend our time. Let's say that there's a project that you're working on that you hope could be an interesting side project or side hustle that could bring you a little bit of extra income every month. So you spend $3,000 or $4,000 building out this side project, and you try to sell it, but like nobody's buying, right? You don't want to admit that what you've already invested is just not gonna work out. So you double down. You throw good time and money after bad, and you do it not because of a rational analysis of your future prospects but rather because of the emotional toll of just not wanting to admit failure. That's sunk cost fallacy.
The reality is none of us will ever overcome our cognitive biases. It's how our brains and our emotions work, and it's part of what it is to be human. Even professional financial analysts. There's a famous quote that "An analyst is only as good as their biases." What we need to do instead is to, number one, accept the fact that we have them, and, number two, develop a very strong sense of self-awareness so that we can notice when these biases are coming up for us and we can stop. We can face them head-on, we can slow down, and we can say, "Hey, is this genuinely a rational decision that I'm making, or am I rationalizing my decision based on the biases that are influencing me?"
About the expert: Paula Pant
Host, Afford Anything Podcast
The Handmaid's Tale
Cognitive biases are essentially predictable ways that our brains fool us. When we fall into these thinking traps, we allow ourselves to be hijacked by essentially emotion disguised as reason.
Loss Aversion
Loss Aversion refers to the fact that the pain of a loss is much deeper than the joy of a gain. We see this, for example, when we're investing. The pain of money that we've worked so hard to earn disappearing feels so much more emotionally resonant than the joy of seeing money that we haven't earned with our time, effort, or sweat magically appear or mysteriously appear through the magic of compounding growth. We might be prone to investing more conservatively than we actually need to, and the result of that may be that over the long term, we end up earning less through our investment portfolio than we otherwise could have. Or it might mean that when the market drops, like at the beginning of the pandemic, we panic and we sell, and we lock in those paper losses and turn those into real losses. That's how loss aversion can lead us astray.
Negativity Bias
Negativity Bias means that if something negative happens, we give it more weight than the positive things that have happened. And if you post something on Instagram, and ten of your friends say, "You look great," and then one person says, "Oh, you're an idiot, or you look ugly," you're gonna remember that one person more than you're gonna remember the other ten. If we have one bad experience with investing, then that can sour our feelings about investing. Maybe you have a bad experience owning a rental property. You have a nightmare tenant. It might not even have happened to you. Maybe it happened to your mom or dad, or to your cousin, to someone you know, but that one experience that happened to one person somewhere at some time has such a profound emotional impact that it knocks you out of the game, and you stay away from owning rental properties for years, for decades, maybe for your entire life. One experience can do that to you.
Overconfidence Bias
Overconfidence Bias is the bias in which we think that we're better at something than we actually are. For example, most people believe that they are above-average drivers, which is mathematically impossible. There's a well-documented effect called the Dunning-Kruger Effect, in which people who know the least about a topic believe that they know the most about it. They're operating at what's called the level of “unconscious incompetence,” meaning they don't know what they don't know. They underestimate the depth, the nuance of that field. By contrast, people who are actually experts in a given field are less confident than the people who know nothing because they know enough about that field to recognize how much they don't know. So let's link that to the world of investing. If you don't know a whole lot about stock investing, real estate investing, or cryptocurrency investing, then you might take some hot stock tip at the water cooler and it sounds good because you don't know enough to be able to exercise critical judgment about it. And you have that level of overconfidence that comes from ineptitude.
Anchoring Bias
Anchoring Bias happens when you see a given price point and that initial price point that you see then anchors in your mind as what that price point ought to be. And any comparison that you make is made based relative to that anchor. You'll see, for example, people say, "Oh, I used to be able to buy this particular house at 123 Main Street for $200,000, and today it's worth $300,000. And because there's such a difference between what my brain has anchored at and what it's worth today, I'm going to judge it based on its previous value." Now, the problem with that is that it can cause you to have a poor understanding of how things should be priced in the present. You pass up homes that are good deals, and you pass up stocks that are good deals because you're thinking about what Apple or Tesla used to be worth five years ago. You accept job opportunities that don't pay as well as they ought to because you're anchored to what you used to make five years ago versus what you really could command today. Anchoring bias skews what we think we can both command and spend.
Sunk Cost Fallacy
And our final example is something called Sunk Cost Fallacy. If I've invested a given amount of money or time into something, I don't want the emotional pain of feeling that that has gone to waste. Let's say that I've bought a stock and that stock goes down. Instead of reevaluating, "You know, was it a wise decision for me to buy that?", I might instead say, "All right, well I'm just gonna dollar-cost average all the way down," and then just start throwing good money after bad in the hopes that if I can continue to buy it on its way down, it'll eventually come back up. The reality is a given stock doesn't care what I bought it for, and just because it's gone down doesn't mean it's going to necessarily go back up. And the same thing happens with the way that we spend our time. Let's say that there's a project that you're working on that you hope could be an interesting side project or side hustle that could bring you a little bit of extra income every month. So you spend $3,000 or $4,000 building out this side project, and you try to sell it, but like nobody's buying, right? You don't want to admit that what you've already invested is just not gonna work out. So you double down. You throw good time and money after bad, and you do it not because of a rational analysis of your future prospects but rather because of the emotional toll of just not wanting to admit failure. That's sunk cost fallacy.
The reality is none of us will ever overcome our cognitive biases. It's how our brains and our emotions work, and it's part of what it is to be human. Even professional financial analysts. There's a famous quote that "An analyst is only as good as their biases." What we need to do instead is to, number one, accept the fact that we have them, and, number two, develop a very strong sense of self-awareness so that we can notice when these biases are coming up for us and we can stop. We can face them head-on, we can slow down, and we can say, "Hey, is this genuinely a rational decision that I'm making, or am I rationalizing my decision based on the biases that are influencing me?"
About the expert:
Paula Pant
Host, Afford Anything Podcast
4 months ago | [YT] | 2