Five Common Behavioral Biases That Lead to Bad Decisions!

May 18, 2022 – By Frank Corrado, CPA, CFP®, RLP.

Investing one’s hard-earned money can be very stressful, especially in our current environment of volatility and constant media attention. To make matters worse, Behavioral Finance is a field of study that focuses on psychological factors that influence our financial decisions. Behavioral biases are unconscious beliefs that can sway our judgments and lead to irrational missteps with our money.

Here are five of the more common behavioral biases that influence our decisions about our money. We all possess them to some extent, but we are more likely to avoid bad decisions if we can identify the bias as part of our thought process. 

1. Mental Accounting

Mental accounting refers to the concept where we treat money differently depending on where it came from and what we think it should be used for. Nobel Prize winner Richard Thaler introduced the concept of “Mental Accounting” in his 1999 paper “Mental Accounting Matters.” If we place the value of money differently, it exposes us to irrational decisions. The concept suggests that we do not treat money as fungible – i.e., mutually interchangeable – and instead link how it’s spent to particular “budgets.”

Consider the rationale for these real-world situations. Do any sound familiar?

1. “My bonus is different than my paycheck. I deserve to be extravagant with my bonus money!”
2. “Can I have a higher amount of tax withheld from my paycheck? I always take a trip with the refund.”
3. “I won the lottery! Now I can buy things I never planned for.”
4. “I’m winning $300 on the blackjack table. Let me keep playing because I am playing with ’house money.’”
5. “I would like to open a separate investment account for speculation. I will only use the money I can afford to lose!”
6. I don’t want to pay off my credit card debt with the money I have set aside for college because it is already accounted for!”

In each of these examples, people make rationalizations about their money, leading to irrational decisions.

2. Loss Aversion

Loss aversion is a tendency where people are so fearful of losses that they focus more on trying to avoid losses than on making gains. Studies have proven that, when making decisions, people are more sensitive to losses than they are to comparable gains. Research estimates that we fear the pain of loss twice as strongly as we feel the enjoyment of making a profit.

Consider the rationale for these real-world situations. Do any sound familiar?

1. “I have a small gain in your suggested mutual fund. Let us sell it before it loses money!”
2. “I know the position has gone down, but I will lose money if I tax-loss harvest and sell now.”
3. “I have lots of scuba gear in storage which was expensive to buy. I don’t dive much, but it’s still not worth selling the equipment at a loss!” (Replace scuba with golf, camping, skiing, exercise equipment, and it still works).
4. “My friend sells annuities, and he told me that they have a product that allows upside potential but limits my downside losses. Should I buy one?”
5. “We fell in love with the vacation home, and our broker said there were many people interested in the property. I want to make a bid over the asking price with no contingencies. We don’t want to let this one get away, and who knows when there will be another one quite like it!”

Loss is inevitable because those seeking rewards must take a risk. Once you take a risk, even the slightest risk, there is a chance to lose something you once had. But the alternative, living a life void of risk, is pretty much impossible.

3. Overconfidence Bias

Overconfidence bias is the tendency to see ourselves as better than we are. Holding a false or misleading assessment of our skills, intellect, or talent can be dangerous and incredibly prolific in finance and capital markets.

Consider the rationale for these real-world situations. Do any sound familiar?

1. “You have asked us to rebalance our portfolio considering the recent downturn. I think the market is in a downward spiral, and I am not interested in adding to the portfolio until we hit bottom!”
2. “I don’t want to invest any money outside the United States. It’s too risky, and the investments usually lose money.”
3. “A good friend gave me a tip to buy “XYZ” stock. I want to buy some because he knows what he is doing and says he never loses money.”
4. “Yes, I am still waiting for that promotion, and my bonus is down a bit this year, but I am confident that if I just ’hang in there,’ I will be successful at this company. I’m too valuable to them. Besides, why change and take the risk it won’t work out!”
5. “I don’t understand why I can’t take a deduction for my home office because there is a king-size bed and a large-screen TV in the room. Can’t I take a nap?”

I am a big fan of a positive self-image, an optimistic outlook about life, and believing in yourself, but if you’re overconfident and tend to misjudge your value, opinion, beliefs, or abilities when considering impactful actions that involve risk, it can have disastrous results.

4. Anchoring Bias

Anchoring bias occurs when people rely on pre-existing information or the first bit of information we learn when making decisions. This bias explains the psychological power of the “first impression,” which usually manifests itself at the beginning of a relationship. If you “hit it off” with someone you are meeting for the first time, you will likely work hard to maintain the relationship, despite a rocky road that subsequently appears. On the other hand, it is difficult to warm up to a new relationship when your first thought is, “he/she is a jerk!”

Consider the rationale for these real-world situations. Do any sound familiar?

1. “There is no way I will spend $1,200 on a wedding cake. My first car didn’t cost $1,200.” (Steve Martin in the movie “Father of the Bride”)
2. “Why should I exercise my stock options at $20/share? I exercised options last year at $35/share.”
3. “This house for sale is a steal. There is one on the cul-de-sac that sold for 35% more.”
4. “Why would I take out a 5% mortgage now? They were at 3% only two months ago.”
5. “I made a great deal at the car dealer; they took $5,000 off the sticker price. I guess there’s no reason to shop around.”

In our fast-paced world, where decisions are needed in “real-time,” our anchoring bias reduces the cognitive load placed on our brains. It provides us a semblance of comfort that our decisions have been thought through and well rationalized. This is fine when guessing the number of marbles in a jar but might not be effective in arriving at a college savings plan for your children.

5. Herd Mentality Bias

Herd behavior happens when you follow what others are doing rather than making your own decision based on your analysis of the facts. Herd mentality is often the root cause of the creation and subsequent bursting of economic bubbles. From the Dutch Tulip Mania in the 17^th Century to the Crash of 1929, the Dotcom Bubble burst in 2000, and the Housing Bubble and Credit Crisis of 2007, among many others, we have had plenty of opportunities to learn from past mistakes. But we never do! FOMO – the fear of missing out is now part of our vocabulary, and it sounds better than herd mentality. Because we are hard-wired to herd, we have come to expect and almost trivialize this behavior, making it even more potentially devastating.

Consider the rationale for these real-world situations. Do any sound familiar?

1. “Why don’t you recommend I invest in cryptocurrency? Everyone is making so much money.”
2. “All my friends are downsizing and moving to Florida to save on taxes. I’m thinking of contacting a local realtor.”
3. “I hear that Congress is considering a reduction of the estate tax exemption. Shouldn’t I set up a trust that saves estate tax before it’s too late? Other people I know are doing so.”
4. “The housing market is so hot now. I want to buy a new home before the prices get crazier and interest rates go through the roof.”
5. “The stock market is in free fall. Everyone is selling; is it time to get out? (It happens all the time – known as capitulation and the perfect time to buy on sale!)

Researchers discovered that it takes a minority of just five percent to influence a crowd’s direction – and the other 95% follow without realizing it. I would never think about starting “the wave” at a sporting event, but I will stand up when it comes my way!

Good news and bad news are just the other sides of the same coin. Inherently, neither is a prescription of what to do next, but another piece of information to help shape your own opinions and action plans.

Conclusion

We all face these psychological barriers in everyday life, and if we don’t recognize them happening to us, we will probably make suboptimal decisions. In hindsight, the rationale is often irrational. For important decisions you are considering, make sure the primary reasons do not include “everyone else is doing it.” Seek out competent financial guidance from someone you can trust and get a second opinion or an alternative way to think about the impact.

Making a wrong decision in life is inevitable, but any “wrong” decision made with the correct reasoning can be considered a learning experience rather than a mistake.