Cognitive Biases That Can Mess Up Your Financial Wellbeing
A few weeks ago, Business Insider published an awesome infographic that showed 20 cognitive biases that can screw up your decision making. While reading it, I couldn’t help but notice how easily these biases can come into play when making financial decisions. I could easily cite a number of experiences in my own life where my finances suffered due to my own preconceived notions or perceptions, and I’m sure the same could be said for many of you. So, with that in mind, I’d like to share what I think are some of the most damaging cognitive biases to your financial wellbeing.
1. The Ostrich Effect
Have you ever found yourself dreading your bills so much that rather than opening them you tossed them into the garbage or hiding them deep inside a drawer instead? The decision to ignore negative information by “burying” one’s head in the sand is known as The Ostrich Effect, and it can have a big negative impact on your financial wellbeing. While keeping your problems out of sight and out of mind might provide some short-term mental relief, it’s really only making your problems worse. Recognizing your bias and getting into the habit of facing your problems head on can help you get back on the right track towards financial stability.
2. Outcome Bias
Outcome bias essentially boils down to placing too much stock in results as opposed to the process it took to achieve them. For example, let’s say you decide to take a trip to Vegas and wind up making a killing. While there’s no doubt that investing (and I use that term lightly) $500 in gambling and coming back home with $5,000 is an awesome return, the decision to use that money to gamble probably wasn’t the wisest one. Allowing ourselves to become too focused on the outcome of our decisions as opposed to the steps we take to get them can result in adapting unsustainable habits and could eventually lead us falling back into financial instability.
3. Availability Heuristic
The availability heuristic is based upon the idea that if something can be easily remembered, it must be more important than other ideas that cannot as easily be recalled. In other words, a person who is under the influence of the availability heuristic is more likely to rely on solutions that come to mind quickly as opposed to those that develop by processing all the information that’s available to them. When it comes to finance, relying too heavily on rules of thumb or overly simplistic words of wisdom can actually hamstring you and keep you from reaching your true potential. Just because it’s easier for you to remember a generalized snippet of advice doesn’t mean that it’s the best choice for your situation. If you’re faced with a big financial decision, take the time to look at it from all angles and consider all of your options; not every choice is a simple one.
As you become more proficient in your financial decision making you’ll probably find yourself making less mistakes. While this is definitely a good thing, it’s important to remain humble amidst your accomplishments. Overconfidence can lead to developing a sense of invulnerability and, consequently, making riskier decisions. Taking pride in our success perfectly fine, but it’s pivotal to keep in touch with reality and remember that it doesn’t take much to fall back into financial instability.
Providing you remain self aware and allow for some time to contemplate your decisions, you should be able to avoid falling victim to many of these cognitive biases. As I always say, knowledge is power when it comes to finances, and knowing yourself is an integral part of that. Have you ever fallen victim to one of these biases? Let us know in the comments below!