No matter the level of experience or your ability as an investor, understanding psychological biases such as availability bias (also known as bandwagon effect), misinformation effects and confirmation bias is key for making rational financial decisions. These psychological influences include availability bias (bandwagon effect), misinformation effects and confirmation bias.
These cognitive errors may also cause you to miss investment opportunities, for instance fear of loss causing you to remain invested for too long, thus avoiding riskier investments and potentially reaping their rewards.
Optimism bias
Optimism bias is a cognitive bias in which people overestimate the probability of experiencing positive outcomes while underestimating its probability. This cognitive distortion can have serious repercussions, including inadequate preparation for risks and challenges (e.g. ignoring health risks from smoking) as well as poor financial decisions (e.g. investing too much money in risky stocks).
Note that optimism bias depends on several variables, including personal attachment tendencies and future events’ social context. Therefore, when researching this bias it is vitally important to use a reliable methodology.
Studies that employ this strategy often use scenarios with differing controllability or frequency characteristics that could potentially alter results; such as using very frequent negative situations to increase optimism bias. This approach has an important bearing on results, especially as its result may influence results of other research.
Availability bias
The availability bias is a mental shortcut that leads people to overestimate the probability of outcomes based on how readily they come to mind. Although commonly employed when making decisions, this cognitive bias may lead to poor decisions when used for making predictable choices. It can be counteracted by seeking out multiple sources of data rather than leaning too heavily on information readily retrievable by memory.
Example: when someone hears of a car crash involving a texting driver, they may assume it to be an everyday occurrence, as media tend to report these cases more than other types of accidents (for instance flooding).
Based rates should always be used when estimating probabilities to make better informed financial decisions and reduce availability bias. You can further decrease risk by seeking multiple sources of data and engaging in self-reflection into daily routine. Subscribe to Maker Mind for weekly insights into creativity, mindful productivity, better thinking skills, and lifelong learning!
Loss aversion
Loss aversion is a cognitive bias in which people tend to experience the discomfort of loss more acutely than pleasure from gain. This phenomenon arises because humans are hardwired to protect against loss. Our species was exposed to evolutionary pressures that put survival at stake; for instance, losing one day’s food meant death whereas gain was less significant.
At times, bias can lead to poor investment decisions. Investors who suffer from it tend to hold onto losing investments with hopes they will recover, even when it would be more rational to cut losses; this phenomenon is known as the sunk cost fallacy.
There are ways to overcome bias. One approach is changing your language when selling products or services – for instance, Taxify framed staying home as an expense rather than an advantage to increase conversion rates.
Confirmation bias
Confirmation bias refers to our tendency to seek information that validates our existing beliefs while disregarding any that contradict them, which can be an issue for investors as it leads them down a path of decision-making without taking in all relevant information that could help make better choices and lead to overconfidence, which negatively impacts performance.
Experts have numerous theories as to why people exhibit confirmation bias, with one such theory suggesting it helps protect people’s self-esteem. When one realizes their beliefs are false, cognitive dissonance occurs which can be both painful and stressful; the confirmation bias helps avoid this by seeking information that confirms one’s current viewpoints.
Another theory suggests that confirmation bias helps people process information more efficiently; however, evidence doesn’t support this view and studies suggest otherwise; in fact, studies show confirmation bias can hinder information processing efficiency.
