15 Biases That Make You Do Dumb Things With Your Money

You are your own worst enemy.

Those are the six most important words in investing. Shady financial advisors and incompetent CEOs don't harm your returns a fraction of the amount your own behavior does.

Here are 15 cognitive biases that cause people to do dumb things with their money.

1. Normalcy bias 
Assuming that because something has never happened before, it won't (or can't) happen in the future. Everything that has ever happened in history was "unprecedented" at one time. The Great Depression. The crash of 1987. Enron. Wall Street bailouts. All of these events had never happened... until they did. When Warren Buffett announced he was looking for candidates to replace him at Berkshire Hathaway, he said he needed "someone genetically programmed to recognize and avoid serious risks, including those never before encountered." Someone who understands normalcy bias, in other words.

2. Dunning-Kruger effect 
Being so bad at a task that you lack the capacity to realize how bad you are. Markus Glaser and Martin Weber of the University of Mannheim showed that investors who earn the lowest returns are the worst at judging their own returns. They had literally no idea how bad they were. "The correlation between self-ratings and actual performance is not distinguishable from zero" they wrote.

3. Attentional bias
Falsely thinking two events are correlated when they are random, but you just happen to be paying more attention to them. After stocks plunged 4% in November 1991, Investor's Business Daily blamed a failed biotech bill in the House of Representatives, while The Financial Times blamed geopolitical tension in Russia. The "cause" of the crash was whatever the editor happened to be paying attention to that day.

4. Bandwagon effect 
Believing something is true only because other people think it is. Whether politicians or stocks, people like being associated with things that are winning, so winners build momentum not because they deserve it, but because they're winning. This is the foundation of all asset bubbles.

5. Impact bias 
Overestimating how big of an impact an event will have on your emotions. Most people are utterly terrible at predicting how happy they'll be after receiving a raise, or getting a new job, particularly as time goes on. We get used to more (or less) money quickly, but it's extremely difficult to realize that before it happens. Your financial goals might change after coming to terms with this.

6. Frequency illusion 
Once you notice an event, it seems to keep happening over and over. But it's often not; you're just paying more attention to something you were once oblivious to. The 2008-09 market crash was such a memorable event that I think investors and the media became infatuated with today's "volatile market." But the last three years have actually had below-average market volatility. We're just more attuned to normal market swings than usual.

7. Clustering illusion
Thinking you've found a pattern by taking a small sample out of a much larger one. For example, we know stocks' daily movements over time are random and unpredictable, but you could take a four-day period where a stock went up, up, down, down, and think you've found a trend. Day traders are attracted to clustering like bugs to bright lights.

8. Status quo bias
Irrationally wanting things to stay the same. People do this in part because they want to avoid costs even when they're offset by a larger gain -- a process psychologists call "loss aversion." You stick with the same bank even though it charges higher fees than another. You hold onto a stock you inherited even when you know little about it. You don't make changes to your portfolio even when it's not designed for your goals. You just want things to stay the same -- a dangerous mind-set in a world that's always changing.

9. Belief bias 
Accepting or rejecting an argument based on how well it fits your pre-defined beliefs, rather than the objective facts of the situation. Pointing out that inflation has been low for the last five years is still met with suspicion by those who believe the Federal Reserve's actions must be causing hyperinflation.

10. Curse of knowledge
When educated people can't comprehend that lesser-educated people think and act differently from them. Financial advisors and journalists fall for this all the time, spouting off lingo and catch phrases without realizing their customers have no idea what they're talking about (and are too afraid to ask for clarification). This also explains why there's a wide gap between academic theory and real-world reality. Economists who understand finance wrongly assume lay people will act in their best interests. Wall Street banks rightly assume they won't.

11. Gambler's fallacy 
The belief that future events will be shaped by past events, even when the two have no correlation. A gambler will assume a coin is due to come up heads after flipping a string of tails, but the outcome of the next flip is completely independent of the last one -- the odds are still 50/50 regardless of prior flips. Investors fall for a version of gambler's fallacy when assuming things like economic data, quarterly earnings, and politics will dictate the direction of the market, when in reality the two often move independent of each other. Randomness is hard to accept.

12. Extreme discounting 
Preferring a small but immediate payoff over of a larger payoff down the road. Some discounting is rational, but investors consistently take it to the extreme. People who have decades ahead of them to invest trade in and out of the market to avoid small, short-term losses, almost always at the expense of long-term returns.

13. Ludic fallacy 
Coined by Nassim Taleb in The Black Swan, the naive belief that the real world can be predicted with mathematical models and forecasts. It leads people astray because models are purposely simplified while the real world is incomprehensibly complex. As author Dan Gardner says, "No one can foresee the consequences of trivia and accident, and for that reason alone, the future will forever be filled with surprises." Ninety percent of stock analysts and economists would disappear if we'd all just accept the ludic fallacy.

14. Restraint bias
Overestimating your ability to control impulses. Studies show smokers in the process of quitting overestimate their ability to be say no to a cigarette when tempted. Investors do the same when thinking about the temptation to do something stupid during market bubbles and busts. Most investors I know consider themselves contrarians who want to buy when there's blood in the streets. But when the blood arrives, they panic just like everyone else.

15. Bias bias
The most important and powerful bias of them all, "bias bias" is the belief that you are less biased than you really are. If you read this article without realizing I'm talking about you, you're suffering from bias bias.

Everyone is prone to cognitive errors. Some more than others, but no one is exempt. Coming to terms with the idea that you are your own worst enemy is the single most important thing you can do to become a better investor.

Daniel Kahneman, who won the Nobel Prize for his work studying cognitive psychology, once said, "I never felt I was studying the stupidity of mankind in the third person. I always felt I was studying my own mistakes." When you realize you are as biased as everyone else, you've won the game.

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

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Read/Post Comments (34) | Recommend This Article (157)

Comments from our Foolish Readers

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  • Report this Comment On August 30, 2013, at 4:37 PM, mark516119966 wrote:

    Thanks Morgan for an interesting acticle as usual about the other investors other than myself.

    I do have a question about #10

    Economists who understand finance wrongly assume lay people will act in their best interests. Wall Street banks rightly assume they won't.

    Maybe I read it too many times but is it:

    Economists who understand finance, wrongly assume lay people will act in their best interests. Wall Street banks rightly assume they won't.

    OR

    Economists who understand finance wrongly, assume lay people will act in their best interests. Wall Street banks rightly assume they won't.

    Are you saying Wall street banks assume a person won't act in their best interest? I surely look around and see a lot of people acting in their own interests. Again maybe I didn't read very well, or even very good :)

  • Report this Comment On August 30, 2013, at 4:42 PM, stockdissector wrote:

    Great article Morgan. My last is Bias so I have Bias Bias bias a triple whammy.

  • Report this Comment On August 30, 2013, at 4:52 PM, stockdissector wrote:

    I definitely know your'e talking about me. Biases definitely provide a fog on the proverbial lens of researching publicly traded businesses. We simply need to accept that risk will always be present when owning a business including the risk of personal misjudgment. That's a difficult one for me to accept because I don't like making mistakes.

  • Report this Comment On August 30, 2013, at 4:58 PM, jordanwi wrote:

    I derive so much pleasure being outed as silly and irrational.

  • Report this Comment On August 30, 2013, at 5:11 PM, bobcham wrote:

    Morgan,

    You have taught me the most of any other writer on the Fool. I appreciate the fantastic stock research and insights from everyone here at the Fool but your straight talk with facts is the first thing I would suggest people read when they come to this great site.

    Thank-you!!! Keep up the great work. I hope to meet you one day. From Canada.

    Bob

  • Report this Comment On August 30, 2013, at 5:16 PM, talotu wrote:

    I don't know that I agree with

    "When you realize you are as biased as everyone else, you've won the game."

    For this to be true, you are saying that either everyone has the exact same amount of bias, or the only way to "win the game" is to be the most biased person in the room.

    I would have also included over-confidence in this list somewhere, the studies on people's inability to set correct confidence intervals are striking.

  • Report this Comment On August 30, 2013, at 6:28 PM, Kimmydooz wrote:

    I enjoyed this article sooooo much. I just heard on the news that people who worry about money have lower IQ scores ("temporarily"). Well, I shall begin embracing the idea I am dumb as a rock today because I have done nothing but worry about money since I was 17 (in my 40's now).

    In my house, the word for "bias" is "perspective" and it is always "The way you look at things." Why would investing be any different than deciding what to buy at the grocery store? You read the labels. You hope they aren't lying. You search for things on sale. You pick one brand over another because your best friend swears by it or the commercials did their job of swaying you.

    I loved having this concept so smartly explained. I was feeling really bad about my "dumb rock" status today. Your article made me feel better.

    Thanks.

  • Report this Comment On August 30, 2013, at 9:34 PM, pcbjoe wrote:

    Well put. You can always count on a Fool to make sense

  • Report this Comment On August 31, 2013, at 12:30 AM, CHill8008 wrote:

    I would also like to add the Anchoring Bias: when you may see a P/E or even a stock price (a piece of info), anchor to that and changes from that anchor will be weighed too heavily. I find this to be accurate for me. While we are each subject to biases, Kahneman also describes ways to mitigate biases: Externalizing and Mechanizing your most lucid moments to your weakest moments with things like lists and rules can be helpful.

  • Report this Comment On August 31, 2013, at 7:55 AM, hcmc130 wrote:

    Great article, I see these forms of biases creep into manufacturing projects, when trying to improve process, determine root cause of problems etc.

  • Report this Comment On August 31, 2013, at 9:46 AM, KayakerRW wrote:

    Great article. I recognize a few of those biases in myself.

    As a teacher, I have moved away from teaching the old model of pro vs. con arguments to having my students identify and evaluate their biases and those of their sources as they study an issue.

    It is hard to do, but we can get better at recognizing our biases. Instead of reacting to information with either "Brilliant" or "What an idiot," we can ask ourselves: "What does this writer know that I don't?" and "What do I know that this writer doesn't?" and perhaps most importantly: "What is important information that neither of us knows and where can I find it?"

    If we spent more time teaching people these skills it would make us all smarter investors and smarter citizens.

  • Report this Comment On August 31, 2013, at 11:27 AM, duuude1 wrote:

    Hey Morgan,

    What can we do to counteract each of these biases?

    I loved your article on what you plan to do when the market crashes - having a quantitative plan in place (market falls X amount and I will invest Y amount...) is a brilliant way to try to take the emotion (fear) out of investing. Even better is if we can set up automatic buys so we have no excuse when the time comes...

    Anyways, you list a bunch of these biases and told us what they are - but what dumb things do we do as a result? And what can we do to prevent that stupidity?

    1. Normalcy bias

    - sounds like run-of-the-mill lack of imagination; but to anticipate risks "never before encountered" starts to impinge of Rumsfeld's famous "unknown unknowns". What does Buffet do to mitigate normalcy bias?

    2. Dunning-Kruger effect

    - perhaps keeping a spreadsheet or using your broker's performance tracking app might help bring the big fish back to a realistic size. Would putting this data in front of these terrible investors improve their performance?

    - something about this effect and the quote "The correlation between self-ratings and actual performance is not distinguishable from zero" bothers me.... Assuming investors with the best returns have the best knowledge of their returns, there should be a strong correlation between self-rating and performance - am I missing something?

    3. Attentional bias

    - again - what stupid things do we investors do as a result of this bias - and how can we prevent doing them?

    4. Bandwagon effect

    - my guess is that this is perhaps the most powerful bias, and the one most people will be incapable of mitigating. People are social animals, and I believe it takes an unusual personality to truly be contrarian and independent. Look at all the people who bought gold recently, who bought houses up to 2007, who bought internet stock up to 2001, who bought....

    - is there something that most of us who are not wired like Warren can do to avoid following the crowd, slowing down and rubber-necking at a wreck, circling around and just watching when a couple kids fight, and jumping into gold just because it's going up, etc...

    etc etc

    Duuude1

  • Report this Comment On August 31, 2013, at 5:19 PM, Chontichajim wrote:

    Many financial site articles begin with a premise, end with a conclusion, and presents "facts" which only support the premise/conclusion. Whenever I see this format my "failure to present both sides bias" causes me to dismiss the article.

    If someone makes a conclusion they do not need to avoid data which would challenge it. After all 60% confidence is pretty good, while 100% confidence is merely "belief bias".

    Does any operating system or App supply a bias filter? It would save a lot of reading time.

  • Report this Comment On August 31, 2013, at 5:57 PM, Mathman6577 wrote:

    Bias #3 is important to avoid in today's environment. I've heard and read many different things about why the market is "dropping" right now and why it probably will continue to drop ---- Fed tapering, debt limit approaching, Syria, declining corporate earnings, the lingering effects of the sequester and the expiration of the payroll tax.

  • Report this Comment On August 31, 2013, at 8:09 PM, SkepikI wrote:

    An interesting article Morgan, worth some extended attention. And I can't resist pointing out YOUR normalcy bias, re hacker attacks not fundamentally affecting the long term market... hmmm ; -)

  • Report this Comment On September 01, 2013, at 5:51 AM, CraigWPowell wrote:

    Agree with all 15 bias types.

    As for me in order not to be biased I use some algorithmic system that track money movements between the markets like:

    * TM system

    ** I Know First algorithmic system

    with good results so far.

    Good Luck!

  • Report this Comment On September 01, 2013, at 10:29 AM, charliebear240 wrote:

    Totally enjoyed this article but it's kind of a catch-22 isn't it? If 90% or more of the "traders" in the markets are playing by these biases and a few are not, it could work against you knowing your own biases. It seems to me the main market movers are due to traders being highly "emotional". Being logical or contrary to the biases won't give you an advantage.

    It appears then that old style investing is still the best: pick a good portfolio based on fundamentals and go for a long-term ride. Or, as you mentioned in a previous article, invest in an ETF or mutual fund while you can! Cheers to all.

  • Report this Comment On September 02, 2013, at 7:33 AM, Riskysam wrote:

    How about a #16: especially for a young investor that comes here to be educated.

    Paralysis (OVER) analysis:

    Something that happens very often over here at the fool.

    Buy Netflix.

    Don't buy Netflix.

    Why Netflix is great.

    Why Netflix s--cks.

    All these articles over a 24 hr period. We don't come here to be spoon fed. At the very least tell us why the information you are publishing adds new knowledge. Where are your facts and sources.

    Then there is the slow death or neglect of the caps community. Cap members that used to publish no longer do. The Fool is becoming...

  • Report this Comment On September 02, 2013, at 9:44 AM, jlclayton wrote:

    I don't believe that all of the analysis by different MF writers is negative at all. The fact is that on any stock you're going to have a wide variety of opinions, and a good investor will want to look at all sides. In the end you need to understand your own personal investing goals, how much risk you are willing to take on, and how each stock would fit into the balance of your portfolio.

    For me, if I have trouble evaluating a stock because so many different opinions make me unsure of it, that's a sign that I just keep it on my watchlist. I may miss out on a great stock now, but my returns have increased since I fully understand the thesis behind each holding in my portfolio and have reduced the number of trades I make based upon emotion.

  • Report this Comment On September 02, 2013, at 5:13 PM, Seanickson wrote:

    The world may not be able to be predicted by mathematical models but they sure are helpful in understanding what the thesis behind your investments is and what rates of return you can expect. Of course, the simpler the better. Theres really no substitute for a basic DCF analysis with conservative assumptions of ROE and retained earnings.

    One thing that I've learned about the market is that it is far less irrational than I originally thought. However, there are stocks that are priced to deliver decent long-term returns in any market.

  • Report this Comment On September 02, 2013, at 5:26 PM, umh wrote:

    "Economists who understand finance wrongly assume lay people will act in their best interests. Wall Street banks rightly assume they won't." It seems that economist are assuming a perfect world and the bankers are betting people will do what they did last time. This also appears to be a black swan for the bankers if the fools ever get it right.

  • Report this Comment On September 02, 2013, at 5:39 PM, Sotograndeman wrote:

    "Daniel Kahneman, who won the Nobel Prize for his work studying cognitive psychology, once said, "I never felt I was studying the stupidity of mankind in the third person. I always felt I was studying my own mistakes." "

    Following this plausible line of thought, the title of his article, Morgan, should be: 15 Biases That Make US Do Dumb Things With OUR Money

    You are one of us!

  • Report this Comment On September 02, 2013, at 5:41 PM, marei wrote:

    Your article reminds me of the joke where if you don't know who is your annoying neighbor, chances are it's you!!--Tom Reilly

  • Report this Comment On September 02, 2013, at 7:40 PM, ryanalexanderson wrote:

    > Your article reminds me of the joke where if you don't know who is your annoying neighbor, chances are it's you!!--Tom Reilly

    Very true, but even more appropriate is the saying that if you can't see who the sucker at the table is, chances are it's you!

  • Report this Comment On September 02, 2013, at 9:01 PM, daveandrae wrote:

    Buy equities- HOLD equities.

    Everything else is commentary.

  • Report this Comment On September 03, 2013, at 2:47 AM, dice51870 wrote:

    #11 Gambler's Fallacy- is right on when it comes to explaining odds and randomness. However, there is a significant difference between odds and probability. Both need to be included when making informed decisions.

  • Report this Comment On September 03, 2013, at 10:51 AM, szcz wrote:

    The "bandwagon effect" is really apparent in connection with the man made global warming fraud.

  • Report this Comment On September 03, 2013, at 1:05 PM, jhsblue wrote:

    #14 Restraint Bias: When the DOW went below 7,000 in 2009 and the doom-mongers where declaring that it would drop by half-again, I was feeling edgy about staying in the market. Luckily my wife had the presence of mind to say "Just leave the investments alone. We don't need the money right now." She's great because that was absolutely the right thing to do under the circumstances, as was continuing to invest as we always have.

  • Report this Comment On September 03, 2013, at 1:58 PM, ziq wrote:

    "When you realize you are as biased as everyone else, you've won the game."

    I have to disagree with that statement. It won't do just to pat yourself on the back for realizing you're as biased as everyone else. You have to assess what those biases are, and how they may be affecting decisions you're making--no easy task.

  • Report this Comment On September 04, 2013, at 12:14 AM, wishdom wrote:

    Man! I love your writing! I read this article and observed that these biases are far broader than just finance. i sent the URL to my son who is a practicing PhD psychologist. We shall have a fine conversation! Thanks!

  • Report this Comment On September 04, 2013, at 3:51 AM, Hanage wrote:

    Superb. Thanks.

  • Report this Comment On September 06, 2013, at 3:52 PM, Sunny7039 wrote:

    There's another bias that Kahneman talks about at length in his Berkeley lecture, and cites Malcolm Gladwell's Blink as a cogent popular account: The belief that experts always know more than ordinary lay people, and are always better equipped at predicting things like stock prices.

    The remarkable fact is that they are not. The practical result is that most people who listen to analysts, brokers, etc., will do no better -- and may do worse -- than if they ignored all such particularized expert advice.

    An expert is great at describing in detail what has happened in the past, and in the aggregate.

    (If something has happened, we know that it can happen. Of course it doesn't follow that if it can happen, it already has. I realize that this is closely related to 1 and 13.)

    An expert is not too bad at describing all the variables that influenced a past event, though he may be less adept at assessing their relative weight. But even if he's great, this doesn't necessarily translate into a plan of action that will work for you or me.

    I like this article a lot, because I've rarely seen so many biases listed in one place, and explained well. Also, articles on bias often seem to have a smug tone, as if the author is telling us that he himself is above this stuff. Not so for this article! Kahneman's humility should be the real lesson here. The best are those who realize exactly where their limitations lie.

  • Report this Comment On September 06, 2013, at 11:45 PM, Drrobemp wrote:

    There are two types of person regards wealth

    Those who spend more than they earn the poor

    And those who earn more than they spend the rich

    Regardless of how much they earn

  • Report this Comment On September 08, 2013, at 7:19 PM, starchase1 wrote:

    I agree. Except I think I have a bias against psychology.

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