Money Saving Tips
Recognizing Our Biases
Our brains are wired to rely on shortcuts that enable us to function efficiently and make decisions based on previously known data. While that’s convenient in some ways, when it comes to making financial decisions, this can lead us down the wrong path.1
In fact, there are many common patterns of faulty reasoning that are known as “cognitive biases.” The more we understand and recognize our own cognitive biases, the better chance we have to make more informed and well-thought-out financial choices.2
The following are five common cognitive biases that can adversely influence investors when making financial decisions.3
- Anchoring and adjustment bias. This is when we fixate on a target value — often the first one we come across. For example, we may research and decide not to invest in a certain stock. Some time later, the fundamentals of that stock may change to make it more favorable, but our anchoring bias doesn’t allow us to consider it because we already ruled it out in the past.
- Framing bias. This indicates how we react to a situation based on how it is presented. We tend to be more passionate in our desires to avoid a loss than in support of a possible gain. Therefore, whether or not we respond favorably to a new opportunity may rely on how it is positioned when described.
- Representativeness bias. This is how we judge an opportunity based on its similarity to others. For example, we may eschew investing in a retail company because we’ve lost money in retail sector investments in the past.
- Availability bias. This bias favors information that we remember over that for which we have less recall. The bias exists even if our memories are faulty; we may still give incorrect information more weight than information we can’t recall at all.
- Confirmation bias. We tend to prefer to act on information that confirms our pre-existing beliefs. This is especially true with regard to deep-seated beliefs and emotionally charged issues.
1 The American College of Financial Services. Aug. 23, 2017. “The Impact of 10 Cognitive Biases on Clients.” http://knowledge.theamericancollege.edu/blog/the-impact-of-10-cognitive-biases-on-clients. Accessed Jan. 25, 2017.
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