Jason Zweig, columnist for the Wall Street Journal, wrote a book called Your Brain on Money where he speaks to several studies, one of which illustrates how the brain activity of a person making money on their investments was indistinguishable from that of a person on cocaine or morphine. The euphoria of investment gains releases dopamines within the brain similar to those that are released when someone is high on narcotics.
Behavioural finance is the study of how human emotions affect the decisions we make about money. Human behavior is shaped by conscious and unconscious decisions which can be swayed by behavioural biases. Divided between cognitive and emotional, behavioral biases vary from person to person. A cognitive bias is the tendency to follow a personal rule of thumb (heuristic) rather than evaluate a situation objectively. Emotional biases are harder to manage, as they are simply taking action based on feelings, not facts.
Cognitive biases are thought patterns that cause us to deviate from rational thinking. Cognitive biases can be moderated through education and a little bit of self awareness. The trick is that all humans are still prone to emotional biases which are not as easily moderated. This is because an emotional bias is generally irrational, and affects our short-term thinking and decision-making.
While there are numerous cognitive and emotional biases, below we highlight five that seem to have the greatest impact:
- Loss Aversion – Loss aversion refers to the human tendency to dislike losses more than we like to experience a gain. Simply put, people would rather NOT lose $100 than gain $100. When investing during a recession, the sting of a loss could prevent an investor from taking on the level of volatility required to ensure portfolio growth over the long term.
- Overconfidence – This name basically speaks for itself, as this bias represents the tendency for people to believe that they are better or more educated on a topic than they really are. Unfortunately, when it comes to investing, there is no crystal ball and it is hard to know with certainty the direction of the stock market. Overconfidence impacts our ability to make sound investment decisions based on the facts at hand.
- Confirmation Bias – Is the tendency to seek information or interpret information in a manner that supports pre-established views on a decision or topic. If someone believes that a specific oil company is a great investment, they have a tendency to only seek out information that supports this belief and discredit information that offers a conflicting view.
- Mental Accounting – This refers to separating money into various subjective criteria. Think of an employment bonus earned in addition to regular salary. If someone earns $5,000 per paycheck, they are more likely to use that money in a disciplined manner to pay down debt, invest, etc; however, if that same person were to receive a $5,000 bonus, they are more likely to spend it recklessly or with less thoughtful intention. The $5,000 is regarded differently in these two instances, when in reality, it’s still money that should be used in a disciplined manner. This is why it’s important to consider the entire financial situation as a whole, and assess the impact each financial decision has on a long-term plan.
- Anchoring – Anchoring speaks to the tendency people have to use their own experiences to shape future judgment. In the Psychology of Money, Morgan Housel explains anchoring by saying “Your personal experiences make up maybe 0.0000001% of what’s happened in the world but maybe 80% of how you think the world works”. When it comes to investing, people can become anchored on a recent piece of news that they’ve heard, or a story told to them by their neighbour about the latest hot stock.
As we become aware of common biases, we can implement strategies to help guide us back to rational thinking and improve the decision-making process. While it’s difficult to remove biases from our lives, there are ways to minimize their impact on our long-term thinking and decision-making.