How to Overcome 3 Unconscious Biases That Can Keep Your Financial Goals Out of Reach
I laugh when I think back to how naïve I was when I entered the financial services industry. I assumed that people were rational actors and that presenting them with facts and logic was all you needed to change behaviors and get good outcomes.
Then reality smacked me in the face. The interesting truth is that we use logic and the facts to justify decisions—not make them.2
We tend to depend on impulse, emotion, and flawed reasoning when making decisions––not the facts.
And that can make it incredibly challenging for even the smartest folks in the room to make sensible financial choices.2
So, what does it really take to make better decisions with our money?
I would argue that having some knowledge of behavioral psychology and the mental biases that can trip us up with finance helps a lot. I know it’s helped me both with my own financial decision making, as well as with helping clients with theirs.
A Brief History of Behavioral Psychology and Economics
It turns out, I wasn’t alone in believing that humans were rational decision makers. Traditionally, economists also believed that people were rational actors, making decisions based on logical evaluation of available information.
However, economists in the 1980s and 1990s started paying attention to the work of behavioral psychologists which showed that real-world behavior often deviates from this ideal, leading to the development of behavioral economics—a field that blends insights from psychology and economics to explain why we make the financial choices we do.
Early Insights: Challenging Rationality
You can trace the origins of behavioral economics begins to Herbert Simon in the 1950s.3 Simon introduced the concept of "bounded rationality," arguing that our cognitive limitations prevent us from being fully rational. Instead, we use mental shortcuts—heuristics—to make decisions. These shortcuts can lead to systematic biases and errors, challenging the notion that we always act in our best financial interest.
Around the same time, George Katona explored how psychological factors influence consumer behavior. His work laid the groundwork for understanding how emotions and mental states affect our spending and saving habits.5
The Cognitive Revolution and Prospect Theory
Fast forward to the 1970s, a pivotal era marked by the cognitive revolution in psychology. This period brought a deeper understanding of the mental processes behind our decisions. Enter Daniel Kahneman and Amos Tversky, whose groundbreaking work led to the development of Prospect Theory in 1979.
Prospect Theory revolutionized our understanding of risk. It revealed that people value gains and losses differently—highlighting our tendency to be more affected by losses than equivalent gains. This loss aversion explains why we might avoid fair bets or cling to losing investments, despite better options being available.
One of their key experiments involved participants being presented with two scenarios involving potential gains and losses. For example, participants were asked to choose between a sure gain of $500 or a 50% chance to gain $1,000. Conversely, they had to choose between a sure loss of $500 or a 50% chance to lose $1,000. The expected value in both cases is the same ($500), but the experiments consistently showed that people preferred the sure gain over the gamble and preferred the gamble over the sure loss. This illustrated risk aversion in gains and risk-seeking in losses.4
Behavioral Economics Takes Shape
The 1980s and 1990s saw behavioral economics gain traction, especially in understanding financial decision-making. Richard Thaler emerged as a key figure, introducing concepts like "mental accounting"—the idea that we treat money differently based on subjective criteria, like where it came from or its intended use. Thaler also explored the "endowment effect," showing that we often overvalue what we own compared to what we don't.
Thaler's concept of mental accounting was demonstrated through experiments that revealed how people categorize money into different "accounts" based on various subjective factors. For example, one study showed that people are more likely to spend a windfall bonus on luxury items, whereas they might save a regular paycheck increase. This behavior occurs even though, economically, the source of the money should not matter. Thaler's experiments highlighted how mental accounting can lead to poor financial decisions by preventing us from treating all money as fungible.5
Thaler's endowment effect was demonstrated through experiments where participants were given a simple item, such as a mug, and then asked how much they would sell it for. Another group was asked how much they would pay to buy the mug. The selling prices were consistently higher than the buying prices, showing that ownership increased the item's perceived value.6
Let me tell you, I see “endowment effect” play out with clients with regular frequency. They cling to losing stock positions, believing they are worth more than they really are.
Or when it comes to selling their homes, they almost always believe their home is worth more than comps would suggest.
Real-World Applications
The recognition of this field's importance was cemented when Daniel Kahneman received the Nobel Prize in Economic Sciences in 2002, followed by Thaler in 2017. Their work highlighted that to make better financial decisions, we need to understand and mitigate our inherent biases.
Today, behavioral economics informs a wide array of fields, from public policy to personal finance. The concept of "nudging," popularized by Thaler and Cass Sunstein, illustrates how subtle guidance can help people make better choices without restricting their freedom. For example, automatically enrolling employees in retirement savings plans increases participation rates significantly—a simple nudge towards better financial health.7
In personal finance, awareness of behavioral biases is invaluable. Financial advisors now consider biases like overconfidence, herd behavior, and the anchoring effect when guiding clients. By recognizing these biases, advisors can help clients make more rational decisions, leading to better financial outcomes.
3 Hidden Biases Behind Poor Investing Moves
Any of us can experience one or more of these unconscious biases at some point in life. Learning how to quickly recognize them, can help us stay open to new information, guiding us to make well-informed decisions and find better financial opportunities.
1. The Halo Effect
With the Halo Effect, we under-or-over value some options, based on arbitrary factors that we find attractive. Simply put, we see a “halo” around certain options just because of how those options are presented and not based on any facts or actual due diligence.1
The Halo Effect was first described by psychologist Edward Thorndike in the early 20th century. Thorndike conducted experiments with military officers, asking them to evaluate their subordinates based on various attributes such as physical appearance, intelligence, and leadership skills. He found that high ratings in one area tended to correlate with high ratings in other areas, even when there was no logical connection. This suggested that an overall positive impression of a person could "halo" their other traits, leading to biased evaluations.
Further research expanded on Thorndike's findings, showing that the Halo Effect isn't limited to personal evaluations but extends to products, brands, and investments. For example, a well-designed product might be perceived as more effective simply because it looks good. In investing, this means that we might overvalue companies or stocks that are well-presented, regardless of their actual performance metrics.
Investing Example: You have the opportunity to invest in Company A or Company B. Company A is run by an Ivy League graduate who wears a suit during the investment pitch. Company B is operated by a non-Ivy-Leaguer who doesn’t wear the suit when you meet him. So, you invest in Company A because it seems like a better investment, based on the “look” of it and not based on any facts about potential risks or payoffs.1
Sign: “They look more professional, so they’re probably more successful.”
The halo effect can be really strong around certain brands. If you’re wooed into an investment because of brand popularity, take that as a red flag of the halo effect—and make sure you’re not skipping the due diligence before making an investment decision.1
2. Fast Thinking
Under the influence of Fast Thinking, we’re primed to act NOW, without any checkpoints and as a reaction to taking in a lot of info pretty quickly. With that, our thinking speeds up and tends to cut corners, racing with thoughts of riches and making us feel like we have to make a choice—and sometimes a big one—ASAP.
The concept of Fast Thinking, or "System 1" thinking, was extensively studied and popularized by Daniel Kahneman in collaboration with Amos Tversky.7 Their research distinguished between two modes of thinking: System 1, which is fast, automatic, and emotional, and System 2, which is slower, more deliberate, and logical. Fast Thinking helps us navigate everyday life efficiently, but it also makes us susceptible to biases and errors, especially in high-stakes situations like investing.
One illustrative experiment by Kahneman and Tversky involved a simple math problem: "A bat and a ball cost $1.10 in total. The bat costs $1.00 more than the ball. How much does the ball cost?" Many people quickly answer $0.10, a response driven by Fast Thinking. However, the correct answer is $0.05, which requires more careful, System 2 thinking. This experiment highlights how our inclination to rely on quick, intuitive answers can lead us astray.
In the context of investing, Fast Thinking can lead to impulsive decisions based on incomplete information or emotional reactions. For instance, a rapid influx of market news can create a sense of urgency, pushing investors to make hasty decisions without thorough analysis. Recognizing when Fast Thinking is at play allows us to slow down, engage our more analytical System 2, and make more informed investment choices.
Investing Example: You’re in a high-pressure seminar with a fast-talking pitchman who’s highlighting a “golden” opportunity, and you have to act quickly to get in on it. Fast thinking can also take hold when you’re researching investment options in internet rabbit holes, flooded with info and few filters.1
Sign: “There’s not a lot of time left, so I better jump into this “great” investment in a BIG way right now!”
That need to rush is some classic Fast Thinking at play, and it’s not usually behind the best financial choices. Instead, it tends to mislead folks into making big moves quickly, before they’ve considered all or any downsides.1
3. Future v. Present Self
When we’re experiencing the Future v. Present Self bias, we think of ourselves as two different people, and we value our present self more. In other words, we tend to view our “future self” as someone else, and we don’t recognize that our “other” self doesn’t need the same things our “present self” does.1
So, we tend to make financial decisions that benefit our present self more than our future self, leaving us not as prepared as we’d like to be when the future ultimately becomes the present.
The concept of Future v. Present Self bias has been studied extensively in the field of behavioral economics. Researchers have found that this bias is rooted in our tendency to discount future rewards in favor of immediate gratification, a phenomenon known as "hyperbolic discounting." Experiments by psychologists like Walter Mischel, known for the famous "marshmallow test," demonstrated that children who could delay gratification (waiting to receive two marshmallows instead of one immediately) tended to have better life outcomes in terms of academic success and health.8
In the realm of personal finance, this bias manifests when we prioritize short-term pleasures over long-term financial goals. For example, opting to spend money on a luxury item today rather than saving it for retirement reflects this bias. Research shows that individuals often struggle to save adequately for the future because they perceive their future selves as strangers, leading to insufficient preparation for retirement and other long-term needs.
To mitigate the Future v. Present Self bias, financial planners recommend strategies like setting up automatic savings plans and creating clear, tangible goals for the future. By making the future more concrete and immediate, these strategies can help align our present actions with our long-term interests.
Investing Example: You allot 2% of each paycheck, instead of 5%, to your retirement savings because you want more spending money day to day.1
Sign: “Who knows if I’ll live to be 90 or 95?! I’m here now, I’m going to treat myself now!” Trading off the future to “live better” now is a telltale sign of the Future v. Present Self bias. It makes us want the sure thing now, and it can mean we end up stealing from our future self simply because we don’t “know” them or take time to really consider ourselves in the future.1
How to Stop Making Bias-Driven Choices in Finance & Experience Better Results
These aren’t the only hidden biases that we can encounter in our financial lives. Unfortunately, there are many more, and they can subtly taint our perspective and reasoning abilities.2
That’s more likely to happen when we’re facing all-new decisions or the future seems particularly scary. We’re also susceptible to biases when we just don’t know a lot about the choices we have to make.2
The good news is that we don’t have to navigate all of this alone and it’s never too late to learn more and make better money choices tomorrow. Whether you’re facing high-stakes financial decisions or you simply want to make better choices to stay on track for big-picture goals, touching base with a financial professional can help, especially when you’re routinely checking in. That’s how the sharpest investors typically fine-tune their outlook and choices for better results.
Sources:
3. Simon, H. A. (1957). Models of Man: Social and Rational. Wiley.
4. Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-291.
5. Thaler, R. H. (1980). Toward a Positive Theory of Consumer Choice. Journal of Economic Behavior & Organization, 1(1), 39-60.
6. Thaler, R. H., & Sunstein, C. R. (2008). Nudge: Improving Decisions About Health, Wealth, and Happiness. Yale University Press.
7. Kahneman, D. (2011). Thinking, Fast and Slow. Farrar, Straus and Giroux.
8. Mischel, W., Ebbesen, E. B., & Zeiss, A. R. (1972). Cognitive and Attentional Mechanisms in Delay of Gratification. Journal of Personality and Social Psychology, 21(2), 204-218.
This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.
