When it comes to money, investing, and financial decisions, we like to believe we’re making choices based on logic and reason. But in reality, our brains are wired to take shortcuts. These shortcuts, known as cognitive biases, shape how we think, feel, and ultimately act, often without us even realizing it. And when it comes to money and investing, these biases can have a profound impact on the decisions we make.
In this article, we’ll break down:
- What cognitive biases are and why they happen
- The most common cognitive biases that impact investing and financial decisions
- Real-world examples of how these biases influence financial choices
- How to recognize and counteract these biases
Let’s dive in.
What Are Cognitive Biases? (Breaking It Down Like You’re 5)
Imagine you’re about to pick a toy at the store. Your first instinct is to grab the shiny, colorful one, because it looks fun and exciting. But what if I told you that your brain is tricking you? You might think the flashy toy is the best choice, but in reality, you haven’t even checked if it works well or if it’s actually worth the money. That shiny toy? It’s an example of a cognitive bias, a mental shortcut that makes you pick what looks good at first glance, even if it might not be the best decision.
In the real world, we make decisions based on a mix of facts, emotions, and experiences. But our brains don’t always work in ways that help us make the best choices, sometimes, we rely on biases that distort our judgment, especially when it comes to complex issues like money and investing.
Common Cognitive Biases in Investing and Finance
There are dozens of cognitive biases that can affect your financial decisions. Let’s break down some of the biggest ones and how they can influence investing, saving, and spending.
1. Anchoring Bias
What it is: Anchoring bias occurs when you rely too much on the first piece of information you hear (the “anchor”) to make decisions, even when that information is irrelevant or outdated.
Real-World Example: Imagine you’re buying a new phone. You see an ad for a phone that costs $500, but when you go to the store, the salesperson shows you another model that costs $650. Even though the second phone might be more expensive than you expected, you feel like it’s a better deal because it’s only $150 more than the $500 phone. The first price you saw anchored your decision.
In Finance: Let’s say you’re evaluating a stock that once traded at $100 per share. Now, it’s trading at $40. You might think, “Oh, this is a great deal; it was once worth $100.” But this $100 price point is irrelevant now, because the market has changed. Your brain is anchored to that previous price, even though it may not reflect the company’s current worth.
2. Confirmation Bias
What it is: Confirmation bias happens when you search for, interpret, and remember information in a way that confirms your existing beliefs, and ignore information that challenges them.
Real-World Example: Let’s say you’ve decided to buy a certain stock because you think it’s a good investment. You search for news articles and opinions online that support your view. When you find a negative review or a warning sign, you brush it off as irrelevant or “just one opinion.” You might even convince yourself that the company’s potential is still sky-high, despite the evidence pointing to the contrary.
In Finance: If you’re already invested in a company, you might ignore bad news about the stock, telling yourself “this will turn around” because you’re emotionally attached to the investment. In the process, you could be missing critical signs of trouble, leading to bigger losses.
3. Overconfidence Bias
What it is: Overconfidence bias is when people believe they know more than they actually do, leading them to take on too much risk or make decisions without fully understanding the consequences.
Real-World Example: A beginner investor buys stock in a company, after reading a couple of articles and listening to friends. They think they’ve done enough research, but they overlook critical red flags, such as the company’s history of poor earnings reports. Because of their overconfidence, they end up making riskier investments, convinced they can’t lose.
In Finance: Overconfident investors might think they can time the market perfectly. They may buy and sell stocks rapidly, believing they’re making smarter moves than the average investor. The truth? Most professional investors can’t time the market with any consistency, and doing so often leads to higher fees and lower returns.
4. Loss Aversion
What it is: Loss aversion refers to the tendency to prefer avoiding losses over acquiring gains. Losing $100 feels far worse than gaining $100 feels good.
Real-World Example: Imagine you buy a stock for $200, but it drops to $150. Even though the stock may be a great deal at the lower price, you hold onto it for too long, unwilling to realize the loss. Instead of cutting your losses and moving on, you hope the price will go back up, even when all the evidence suggests it won’t.
In Finance: Loss aversion often leads investors to hold onto underperforming stocks or bad investments for too long. This could mean missing better opportunities or continuously losing money as the stock drops further.
5. Herd Mentality
What it is: Herd mentality is when people follow the crowd, making decisions based on what others are doing, rather than making their own informed decisions.
Real-World Example: The cryptocurrency boom of 2017 is a perfect example. As Bitcoin surged in value, many people who knew little about it jumped on the bandwagon, believing that everyone else couldn’t be wrong. When the bubble burst, many of those people suffered huge losses.
In Finance: Herd mentality drives investors to make irrational decisions, such as buying into a trending stock just because “everyone else is doing it.” This can lead to market bubbles, where everyone buys into something at the same time, pushing prices too high, followed by a sudden crash when the hype fades.
How Cognitive Biases Impact Your Financial Decisions
These biases don’t just affect how we think, they can have real consequences on our finances. Here are some concrete ways cognitive biases shape our financial futures:
1. Overtrading:
Overconfidence and herd mentality often lead to overtrading, buying and selling investments based on short-term market fluctuations or emotional impulses. This can lead to missed opportunities and lost money due to fees and poor timing.
Example: In the dot-com bubble of the late 1990s, many people jumped into tech stocks without understanding the companies behind them. When the bubble burst, millions lost their investments because they bought into the hype without doing the proper research.
2. Holding Onto Losing Investments:
Loss aversion causes investors to hold onto bad investments, hoping they’ll rebound, when the smarter move would be to cut their losses and invest in better opportunities.
Example: Many investors in the 2008 financial crisis held onto their investments in banks and mortgage companies, unwilling to sell at a loss. They ended up losing much more as these companies’ values plummeted further.
3. Ignoring Risk:
Overconfidence often leads investors to underestimate the risks of certain investments. Without a realistic assessment of potential losses, people might invest too aggressively in high-risk stocks or products they don’t fully understand.
Example: During the housing bubble of the early 2000s, many investors believed real estate prices could only go up. They ignored signs of a potential crash, leading to massive losses when the bubble burst.
How to Counteract Cognitive Biases in Your Financial Decisions
- Educate Yourself Continuously:
- The more you know, the less likely you are to be swayed by biases. Read widely, look at different perspectives, and make decisions based on facts, not emotions.
- Stick to a Plan:
- Set clear financial goals, create a diversified portfolio, and stick to your plan, even when market fluctuations or new trends make you want to jump ship. Consistency is key.
- Check Your Emotional State:
- If you’re feeling overly confident or overly fearful, take a step back. Emotional investing leads to poor decisions. Make sure you’re making financial decisions based on logic, not emotion.
- Seek Professional Advice:
- If you’re unsure, consider seeking advice from a financial advisor. They can help you make more informed, less biased decisions.
Conclusion: Understanding Cognitive Biases Can Make You a Smarter Investor
Cognitive biases are powerful forces that affect how we think and make decisions. In finance, they can lead to poor decisions, missed opportunities, and unnecessary losses. By understanding these biases and taking steps to counteract them, you can make smarter, more informed financial decisions that will help you build wealth and achieve your goals.
Key Takeaways:
- Cognitive biases impact the way we think and make financial decisions.
- Common biases in finance include anchoring, confirmation, overconfidence, loss aversion, and herd mentality.
- By recognizing these biases and actively working to counteract them, you can make better, more rational financial decisions.
If you’re interested in learning more about how psychology affects investing, check out our article on The Endowment Effect: How It Can Make or Break Your Wealth. This article dives deep into the psychology behind loss aversion and how the endowment effect influences how we handle money.
The Broke College Student 
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