The Battle Between Financial Success and the Human Brain

Everyone has their biases - you, me, everyone! The politics of the last couple of years is nothing if not a testament to this fact.

The reason is that no matter how much someone tries to be 'neutral' or 'impartial' it is exceedingly difficult given how the human brain functions. Simply put, the brain takes in data, filters the data, and arrives at a decision. It is this filtering process that allows for bias, otherwise known as cognitive biases.

These cognitive biases affect our decisions big and small; from what we eat for lunch to the choices we make with our money.

So, you might be asking, what are these cognitive biases? And how do they hinder financial success? I'm glad you asked. Here are a few of the more prominent cognitive biases that affect people's financial success:

Anchoring
This is when people rely heavily on the first piece of information they were given on a topic and rely on that to make their decisions. For example, an investor hears that XYZ is the best sector or product to invest in, maybe they heard it from their parents growing up. But the markets change over time and perhaps XYZ is not a good fit for their current situation. Despite being told this by their advisor, the investor holds on to the belief that XYZ is the best based on what they first heard and insists on investing in it, perhaps to their own detriment.

Confirmation
Confirmation bias is when someone has a stated belief and seeks out new information with the sole intent of reinforcing that belief - avoiding any contradicting information. A person exhibiting this bias also tends to impose their belief on new information whether a relationship exists. Investment crazes are good examples of this. When something new comes on the market there are always investors that divest some or all their assets to place money in the latest big thing. They focus only on positive opinions on the investment and ignore opinions that question the investment's validity, the effect the change will have on the diversification of their portfolio, and their own risk tolerance.

Small Numbers
This bias appears when a person makes generalizations from a small sample size, which can give them inaccurate results and then makes decisions based on these generalizations. For example, people who get investment advice from a small friend group with the assumption that the advice will work for everyone. This friend group may be in a very different situation and what works for one person might not work for you - or a great many people.

Loss Aversion
Loss aversion is the idea that people feel more loss in losing something than pleasure in gaining something. For example, some people would avoid buying a particular investment because they feel it is risky, and that may lose them money in the short term, even if the reward potential is high in the long term. They do this because their fear of a potential loss is greater than the idea of a gain.

These are just a few of the cognitive biases that come naturally to everyone - I have them too. But being more informed about your biases can help you combat the ones that hinder you in both your life and your finances.

Courtney Beach, QAFP – KLT Wealth Management