The 5 Biggest Biases We Fall Victim to

Bruce Schneier, an author who writes about how we perceive danger, gave a great talk at TED recently, outlining five cognitive biases people fall victim to when making decisions about risk.

None of the five were intended to relate to investing, but all of them can teach investors something about the rampant biases we make with our money.

1. We tend to exaggerate spectacular and rare risks and downplay common risks. 
Schneier used the example of flying vs. driving. Driving is statistically more dangerous than flying, yet flying freaks many of us out.

In investing: Most recent polls show investors' biggest fears center around inflation and national debt. These might be legitimate risks, but they pale in comparison to a common risk that utterly derails so many people's finances: We don't save enough. Someone who invests their meager and inadequate savings in gold will still have a rough retirement even if inflation takes off.

2. The unknown is perceived to be riskier than the familiar. 
Schneier's example: "People fear kidnapping by strangers when the data supports kidnapping by relatives being much more common."

In investing: The Flash Crash last May caused untold anxiety. A year later, we're still talking about it posing a serious risk to markets. In reality, though, it was a non-event. The whole thing was over in a few minutes. Most didn't even hear about it until it was over and losses were reversed. What made it scary is that it had never happened before. Meanwhile, the risks posed by the herd mentality of buying high and selling low can be absolutely devastating to long-term wealth -- yet it's culturally acceptable because it's so familiar and prevalent. Anyone who sold stocks in March 2009 and is just now getting back into the market has bludgeoned their portfolio in an irreparable way -- a scar the Flash Crash left on virtually no one.

3. Personified risks are perceived to be riskier than anonymous risks. 
Schneier's (untimely) example: Bin Laden is perceived to be scarier because he has a name. (Note: His talk is a few weeks old.) Same with swine flu; it seemed riskier than it was because it had a name.

In investing: The media are good at blowing risks out of proportion by tying them to personal stories. When markets were sinking last summer, both The New York Times and The Wall Street Journal ran articles with stories of individual investors cashing out and giving up on stocks. They were full of anecdotes like, "Greg Jones has had it with volatility and is done with stocks." Well, good for Greg Jones. What about the other 300 million or so of us? If you looked at the data, there was no evidence individual investors were pulling out of the market in a meaningful way.

4. We underestimate risks in situations we do control, and overestimate risks in situations we don't control.
Here's Schneier: "Once you take up skydiving or smoking, you downplay the risks. If a risk is thrust upon you -- terrorism is a good example -- you overestimate the risk."

In investing: How many out there are drowning in credit card debt and underwater on the mortgage, yet losing sleep over the U.S. Treasury borrowing money at 3% interest? Too many.

5. We estimate the probability of something by how easy it is to bring examples to mind.  
Schneier: "Newspapers repeat rare risks again and again. When something is in the news, it is, by definition, something that almost never happens. Things that are so common they stop becoming newsworthy -- like car accidents -- are what you need to worry about."

In investing: There's a constant parade of commentators warning about runaway inflation in the near future, yet few ever discuss how many investors guarantee themselves poor investment results by overpaying investment advisors and mutual funds for products that often amount to index funds. The latter just isn't newsworthy because we've come to expect that all money managers deserve seven-figure paychecks. For many, overpaying investment advisors over the course of a lifetime poses a greater risk to long-term returns than a temporary surge of inflation.

Check back on Fool.com every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (63)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 10, 2011, at 9:22 PM, ynotc wrote:

    No comments yet? No controversy here. It's true! Thanks for pointing it out. I call this Shark Week fear. Every year when they have shark week on the Discovery Chanel people get upset and fearful despite the fact that you are more likley to be injured or killed in an auto accident.

  • Report this Comment On May 10, 2011, at 11:02 PM, extremist wrote:

    We don't save enough? Unfortunately, those who DO save wind up having the most money when they're least able to enjoy it.

  • Report this Comment On May 11, 2011, at 12:20 AM, PeyDaFool wrote:

    Morgan,

    I'm getting to the point where I feel comfortable giving you a rec even before reading the article.

    Keep it up, buddy.

  • Report this Comment On May 11, 2011, at 9:13 PM, tedkelly27 wrote:

    When it comes to downplaying common risks, the reasons we do it are almost a matter of survival, we have to drive to work, to the grocery store. We can't worry about the potential consequenses. In investing, something that's not critical to "survival" do you think that same instinct applies when it's not "life or death?"

  • Report this Comment On May 12, 2011, at 4:14 AM, whereaminow wrote:

    "Someone who invests their meager and inadequate savings in gold will still have a rough retirement even if inflation takes off."

    This is absolutely true. And as one of CAPS blogs most prominent gold bulls, I have had to remind everyone that reads my blogs on a few occasions that rainy day funds always come first and that PM equities always come last.

    I don't know that this advice is ever followed, however.

    David in Qatar

  • Report this Comment On May 12, 2011, at 5:46 AM, mikeinmadrid wrote:

    OK, but these aren't really the biggest biases in investing. A couple of the most dangerous are

    (1) Anchoring to a price. It is quite difficult to ignore the price paid for a stock when making a decision to sell.

    (2) Selective bias favoring evidence that supports your previously held beliefs and ignoring contrary evidence.

  • Report this Comment On May 12, 2011, at 1:48 PM, drborst wrote:

    @mikeinmadrid

    You beat me to it, i think your second one is named confirmation bias, and I'd rank that #1.

    Also, I'd add a #3 to your list (or a #8 to Morgan's, though it might fit under his risk #2), It's a bias against annoyances, for lack of a better name.

    Two examples:

    I avoid certian stocks because I dislike the more complicated taxes. (You can argue the merits of KMP or CPNO, but I just fear the K1 forms).

    I know a flat tax supporter whose arguement was "Your tax form would be 5 lines with 3 for your name and address"

  • Report this Comment On May 12, 2011, at 2:00 PM, Darwood11 wrote:

    I remember when the movie "jaws" first came to the screen. It was 1975. A relative, who was attending engineering school (BSME) insisted that she and her friends had seen a shark fin on the water near campus. Where was the campus located? The western shore of Lake Michigan!

  • Report this Comment On May 12, 2011, at 4:23 PM, harispicks wrote:

    "In investing: The Flash Crash last May caused untold anxiety. A year later, we're still talking about it posing a serious risk to markets. In reality, though, it was a non-event. The whole thing was over in a few minutes".

    Are you kidding me? It was not a NON event. I remember because I started investing quite cautiously in April 2010 and after May 6th crash my portfolio went down in the red and did not recover till July. I was scared and nervous when great stocks like Amazon that were trading at 137.00$ dipped to 106.00 in a matter of some days... Not sure who made money in all this!!

  • Report this Comment On May 12, 2011, at 4:24 PM, harispicks wrote:

    That said...ok with all other points :)

  • Report this Comment On May 12, 2011, at 4:25 PM, TMFHousel wrote:

    "I remember because I started investing quite cautiously in April 2010 and after May 6th crash my portfolio went down in the red and did not recover till July."

    A three-month dip is a non-event in the stock market. Happens every year.

  • Report this Comment On May 12, 2011, at 5:06 PM, TheMotleyTimbear wrote:

    I'm not really sure how to phrase my question, but do these biases (specifically #1 & #2) affect policy-making? Has the systemic shock of 2008 seemed so dangerous because it was so spectacular and rare, and would that lead to ineffective and possibly bad regulation and policy? Or you could frame it that financial crises are not as rare as they seem...

    Is there smaller, regular behavior by financial market participants that represents a more systematic risk we should be watching out for?

  • Report this Comment On May 12, 2011, at 10:05 PM, inmocean wrote:

    The Flash Crash was NOT a non-event. I had a large position in Coach that fell substantially, hitting my stop limit trigger point and causing a sale. I didn't even know it had happened for several days.

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