Here Are 5 Big Reasons You Make Bad Financial Decisions

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KEY POINTS

  • Cognitive biases often lead us to make bad financial decisions.
  • Confirmation bias is our tendency to seek out evidence that confirms our existing beliefs while ignoring contrary evidence.
  • Survivorship bias is our tendency to inflate our own abilities.

The real reasons behind your poor choices.

We all know what sound financial advice looks like. Be disciplined with your money and don't spend more than you earn. Save and invest for your retirement. Buy low and sell high. Sounds easy enough, right?

Then why is it so hard to follow these simple guidelines? Even financial professionals have a hard time making good financial decisions. This is because our brains are wired in a way that often makes irrational decisions not in our best interests. Cognitive biases and emotional decisions have a major impact on our financial decisions, often leading to bad choices. Here are five big reasons why you may be making bad financial decisions.

What is cognitive bias?

Cognitive bias is a type of mental shortcut that helps us make decisions more quickly by simplifying complex information. Although this may sound helpful, the problem with cognitive biases is that they can lead us to make inaccurate assumptions and judgments based on incomplete or incorrect data. There are many types of cognitive biases, but here are five of the most common ones that we fall prey to.

1. Confirmation bias

Confirmation bias occurs when we cherry-pick information that agrees with our existing beliefs while ignoring facts that challenge those beliefs. This type of bias can be especially dangerous in financial decision making, because it can lead us to overlook important details that could help us make better decisions.

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A great example of this is when we choose investments. If we like a popular stock, we will look for data that confirms our beliefs and overlook data that doesn't. Even top private equity funds ignored the red flags in Sam Bankman-Fried's crypto platform FTX. Investors were drawn to SBF's charisma and investors wanted to believe that SBF was the savior of crypto. They only listened to people who agreed and anyone who raised concerns was shunned. This led to a vicious cycle of investors reinforcing what they already believed. The end result? A million investors, including top private equity funds, lost close to $8 billion when FTX declared bankruptcy last year.

2. Availability heuristic

The availability heuristic is a mental shortcut in which we judge something based on how easily we recall similar situations from memory. For instance, if one stock has gone up in value recently, then we might assume, without doing additional research, that similar stocks will also go up in value. We tend to think that things that happened recently are more likely to happen again. Unfortunately, this type of thinking leads us to make hasty financial decisions or invest in stocks without properly researching them first.

For example, the number of cryptocurrencies on the market more than doubled to 12,000 from 2021 to 2022 as cryptos exploded in value. By the end of 2021, the market was adding 1,000 new cryptos per month. At its height in November 2021, the crypto market was worth close to $3 trillion, and new investors continued to pile their money into new cryptos. Since then, the market has shed two-thirds of its value and investors have lost $2 trillion. Thousands of cryptos have folded, and popular crypto platforms, funds, and exchanges have also gone under.

3. Anchoring bias

The anchoring effect refers to our tendency to rely too heavily on the first piece of information we receive (the "anchor") when making decisions. This is why companies have the manufacturer suggested retail price (MSRP) on the price tag. That is the number they want you to refer to. So if they say a product's MSRP is $100, but it's 75% off, you think you're getting a great deal at $25. But in actuality the price is relative, and the product may be worth only $10.

Anchoring bias leads us to place too much importance on a single piece of information and fail to consider other important factors when making a decision. This bias can lead us to spend more money than we should because we think we are getting a deal we can't pass up.

4. Survivorship bias

Survivorship bias occurs when people overestimate their chances of success by looking at a group of successful people without considering those who failed (and were removed from the dataset). The news constantly highlights the entrepreneurs and startups that have hit unicorn status (valued at $1 billion). In 2022, there were close to 900 companies to join that exclusive list. What isn't highlighted are the millions of small businesses that don't reach that milestone.

This type of thinking can lead people to focus only on those who are successful without taking into account those who are not. For example, the chances of winning the grand prize in the PowerBall lottery is 1 in 292,201,338. Edwin Castro was the winner of the record-breaking $2.04 billion jackpot in November 2022. People reading about him may be motivated to go out and buy more lottery tickets in hopes of winning as well. What we don't read about are the millions of other people who didn't win the lottery.

Another example is investing. Some may see the success of Warren Buffett and believe they can do just as well by following his investing principles. Unfortunately, this can lead them to ignore risks or their chances of failure.

5. The sunk cost fallacy

The sunk cost fallacy leads us to continue to invest or spend money on something that we have already put resources into, even if we no longer believe it is the best course of action. This means we can end up spending a disproportionate amount of money, time, or effort on something because we don't want our previous investment to go to waste.

This leads us to throw in good money after bad, instead of cutting our losses. For example, if we put thousands of dollars into a bad investment, we tend to double down because we don't want to lose the money we already put in. This type of thinking often leads investors to make decisions based on emotion instead of sound research. When encountering this type of situation, it is important to take a step back and not let what you already invested influence your decisions. Often the best strategy is admitting our mistake and cutting our losses, so we can move on. You don't want to make a decision based on past costs, but instead focus on present and future risks and rewards.

Cognitive biases can impact our financial decisions

We can be our own worst enemy when it comes to managing our finances. No matter how much knowledge you have about finance and investing, we are all still subject to various cognitive biases and emotional traps. We don't always make decisions based on reason and long-term thinking; rather, our decisions are often driven by short-term desires and based on incomplete information. While cognitive biases can help us make decisions more quickly by simplifying complex information, these mental shortcuts can also lead us astray if we're not aware of them. Try to recognize when you're experiencing these common cognitive biases, and you'll give yourself a chance to work against them and make informed, responsible choices with your money.

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