11 mental traps when making financial decisions
Are you convinced that your financial decisions are always guided by reason? We are sorry to disappoint you. Some 180 biases have been identified that can condition our analysis of reality and our choices. From 11Onze, we present eleven of the most common ones.
Although we all like to think that we are rational and that our logic is infallible, the truth is that our decisions are constantly exposed to the influence of cognitive biases and some mental shortcuts that distort the analysis of reality. Their impact can condition the choices we make every day if we are unaware of their importance, including in the financial arena.
The scientific literature has already identified some 180 traps in our minds that can lead us to make wrong judgements. Some are quite obvious and you may recognise them in yourself or others. But others are so subtle that they are almost impossible to detect.
Keep in mind that attention is a limited resource, so we cannot evaluate all the details and possibilities when making a decision. As a result, we often get carried away by emotions and subjective opinions, or resort to mental shortcuts that speed up our ability to make judgements and can lead us into error. From 11Onze, we present eleven of these traps and how to avoid them.
This bias means that we tend to pay more attention to information that confirms our beliefs than to information that questions them. Who doesn’t like to be proved right? Overvaluing data that confirms our biases inhibits our critical capacity and prevents us from considering all facts logically and rationally.
So if we think that investing in a particular asset might be a good investment or that switching electricity companies will help us save money, we should not just look for information to support that decision. It is always good to listen to critical voices. Only by comparing the data for and against and weighing them objectively can we make a well-informed decision.
We are prone to be overly influenced by the initial information we receive, which we take as a point of reference. Thus, the first figure that appears in a price negotiation often becomes an anchor point for subsequent negotiations. It has been shown that even hearing a random figure can influence our estimates on a completely unrelated subject.
This is a bias to bear in mind when, for example, we negotiate the price of a house. If we are asked for a very high price and we manage to lower it a little, we may end up accepting the deal with the feeling that we have negotiated well even though the final amount is still above the market price. In reality, however, our counteroffer was probably heavily conditioned by the first price we asked for. Hence the importance of being well informed and avoiding rushing into a decision.
This mental shortcut is designed to save us time when trying to determine risk. It leads us to estimate the probability of something happening based too much on the most accessible information in our brain, such as the number of examples that come to mind.
We tend to overestimate the likelihood of something happening based on how easily we remember something similar happening. This means that, for example, we often decide whether or not to take out home insurance based on whether one of our acquaintances recently suffered a serious domestic mishap. For this reason, it is always advisable to expand our information with external and more global data, which give a more realistic picture of the probability of something happening.
This bias, which is closely linked to the availability bias, is summed up in the saying “better the bad you know than the good you don’t know”. We tend to trust the familiar and distrust the unfamiliar.
This is one of the main reasons why many people prefer to invest in domestic assets rather than foreign ones, even though the returns on the latter may be considerably higher.
- Exaggerated optimism
We tend to overestimate our capabilities and the likelihood of good things happening to us, while underestimating the likelihood of negative things happening to us. This bias is rooted in the availability shortcut, as we tend to accumulate more memories of the negative things that happen to other people and the good things that we experience ourselves. Hence, we find it more likely that negative events will affect others.
The good thing about this tendency towards optimism is that it motivates us to pursue our goals, but we should be humble and not relativise the risks we take. If the economic situation around us worsens, it is foolhardy to turn our backs on saving, thinking only that we will not be affected by the crisis.
We think that two things are more likely to happen when they are similar or similar to each other. Our prejudices lead us to create stereotypes that serve as a basis for judgement. If we have had good experiences with expensive products, it is easy for us to assume that a product is of good quality simply because it has a high price, and this is not always the case. It never hurts to listen to the opinion of other users before purchasing.
- Halo effect
The initial impression we get of a person influences what we think of them in general. This is why we tend to believe that attractive people are also smarter, nicer and funnier. And, financially, that products marketed by such people are also more valuable.
One factor that can influence the halo effect is our tendency to want to get it right. If our initial impression of someone was positive, we will tend to look for evidence to confirm our first impression. Hence the importance of always maintaining a critical spirit.
- Hindsight bias
This bias leads us to see events, even random ones, as more predictable than they really are. Yes, it is the typical “I knew it already” bias whereby so many people claim to have seen a crisis coming when they are already in the midst of it. It happens for a combination of reasons, including our ability to “misremember” previous predictions and the tendency to see events as inevitable.
The truth is that we make predictions all the time, so some of them are bound to come true. Our poor memory of the ones we fail to remember makes it easy for us to become overconfident about our predictions. And this can sometimes lead us to take unwise risks. The antidotes are prudence and humility.
- Gambler’s fallacy
This false belief describes our tendency to think that something will happen because it hasn’t happened yet. For example, if we play roulette and the last few times the ball has landed on red, we might mistakenly assume that the probability that the next outcome will be black is higher. However, these events are independent of each other, so there is no relationship between the probability of the two outcomes. This is something we should bear in mind when chaining bad investments together. Each must be accompanied by a specific analysis.
- Framework effect
As explained in another article, this cognitive bias means that the same information, presented in different ways, can lead to different conclusions. For example, you are more likely to agree to a financial transaction if you are told that there is a 60% chance that it will go well than if you are warned that there is a 40% chance that it will go badly.
This is a very important bias when making decisions that affect your finances. You should carefully assess the information they give you about any proposal they make to you, as it is probably designed to achieve their objectives, and rephrase the data so that it is as aseptic as possible.
- Loss aversion
Our fear of losing is often stronger than the pleasure we experience when we win. When we lose an amount of money, our sense of disappointment is greater than the joy we feel when we win the same amount of money. That is why, when faced with similar probabilities of success or failure, we tend to choose the conservative option.
Ground rules against biases
As the list of cognitive biases is very long, it is useful to apply four basic rules that will help you avoid most of them:
Reflect on past decisions. If you have been in a similar situation before, reflect on the outcomes of the decisions you made to avoid repeating certain biases. For example, because we tend to underestimate the amount of money we need, you can track your spending over the past few months to see how much money you need to budget.
Challenge your point of view. Try to see the weaknesses in your logic, however inconsequential they may seem to you, which is helped by lists of pros and cons. You may be more convinced of your decision if it stands up to serious and critical scrutiny.
Don’t make decisions under pressure. Haste is not a good companion. Although it may not seem like it, very few cases require immediate decisions.
Include outside viewpoints. A second opinion is never a bad thing, so consult someone who is objective and has no stake in the decision. They can provide different points of view, challenge your opinions and detect your cognitive biases.
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