June 19, 2013

Ten Ways People Make Irrational Financial Decisions

As investment advisors, our job is to help our clients make financial and investment decisions. One of the things we watch out for when advising clients is decision-making bias, which can cloud judgment without peoples’ awareness. Studies in behavioral economics have demonstrated a number of ways in which people make irrational decisions, particularly when it comes to financial matters. These biases are surprisingly consistent, allowing behavioral economists to identify and study them. Here are ten (out of many) of the more interesting biases that affect peoples’ financial (and other) decisions:

Availability cascade: This is a process in which a belief that is repeated over and over seems more true the more it is repeated.

Backfire effect: When people are given new information that contradicts a previously held belief, that belief may actually strengthen in response.

Bandwagon effect: People tend to do or believe things because many other people do.

Confirmation bias: People have a tendency to look for information that confirms their already-existing beliefs, or interpret information in such a way that it confirms preconceptions.

Empathy gap: People tend to underestimate how much their (or others’) feelings contribute to their decision-making.

Endowment effect: Once a person owns an object, they will require a much greater price to give it up than they would pay to initially acquire it.

Framing effect: How a person interprets information depends on how or from whom that information is delivered.

Hyperbolic discounting: People will find an immediate payoff to be greater in value than a later payoff. Rewards are “discounted” the further in the future they are.

Negativity bias: People pay more attention to negative experiences or information than positive ones.

Nonsense math effect: People will judge information that is backed up with mathematical equations as more persuasive, regardless of the quality of the equations.

Understanding behavioral economics helps us to reduce or compensate for the hidden influences on peoples’ decision-making. To learn more about behavioral finance, you can read Arnerich Massena’s white papers on the subject, Ain’t Misbehavin’! and Investment Committees: More than the sum of its parts (links below), or follow the additional links below to articles about behavioral and cognitive biases.

http://www.am-a.com/pdf/white-papers/wp_behavioral_economics.pdf

http://www.am-a.com/pdf/white-papers/wp_investment_committees_2010.pdf

http://www.fpanet.org/ToolsResources/ArticlesBooksChecklists/Articles/Investments/KnowYourEnemyCognitiveBehavioralBiases/

http://www.techwell.com/2013/04/cognitive-biases-affect-judgment-and-decision-making

http://www.investopedia.com/articles/investing/051613/behavioral-bias-cognitive-vs-emotional-bias-investing.asp