THE FOUNDERS of economics were prodigious thinkers. They tended to believe that others shared their brainpower and so would do as they did—wrinkle their brow, think deeply and make the best choices with their scarce resources.
Problem is, this isn’t how most of us operate. Instead, we take mental shortcuts. This is understandable: We’d never rise from the breakfast table to begin our day if we rigorously analyzed the health effects of eggs, orange juice and coffee. Evolution has also favored those who thought in shortcuts. If our ancestors pondered whether an object in the jungle was a stick or a snake, they might have been bitten. It was better to react to the uncertainty by jumping away.
The mental shortcuts that humans take aren’t random, but show persistent “leans” or biases. That’s good news. It means many can be identified and countered if we slow down and think a bit harder. To help in this endeavor, here are 17 common financial biases that researchers have identified.
Anchoring. It’s hard to objectively value an asset, so many people rely on shortcuts. As the fair market value, they fix on the price they paid or some peak price the asset reached. Someone who won’t sell for less is said to be “anchored” on a particular price. But assets, alas, have no memory and aren’t obliged to return to that price again.
Availability bias. People overestimate the value of the information that’s most accessible in their memory. If they have a roommate who day-trades meme stocks, it might seem like a more reasonable investment than cold logic would suggest. If everyone in our circle is buzzing about nonfungible tokens, goldmining shares or taxi medallions, their intrinsic worth may seem more certain to us.
Blindspot bias. We’re all subject to biases, but we recognize them more readily in others than in ourselves. It’s safe to assume that we’re all off-base in some way. But we may imagine that we have perfectly sound reasons for every action we take.
Choice overload. Shoppers who encountered 24 flavors of jelly bought less jelly than shoppers who had to choose among six flavors. When faced with a difficult decision, many times we simply decide not to decide. The cost can be high if we put off enrolling in the 401(k) or making an estate plan. Researchers find this is best overcome through simplification—providing one page of step-by-step directions.
Company stock bias. Enron employees held 60% of their 401(k) assets in Enron stock as the company sailed toward bankruptcy. Employees often think company stock is “safe” because the firm’s buildings and brands are ever-present. But any single stock is far riskier than a mutual fund because it’s undiversified, plus workers stand to lose both their job and their savings should the company fail.
Confirmation bias. We tend to value information that bolsters our opinion and dismiss anything that contradicts it. In fact, some people become even more firmly wedded to their opinion as contradictory evidence mounts, like the bearish investors who feel more certain that a crash is inevitable when a bull market charges ahead for decades.
Endorsement effect. If a 401(k) offers five actively managed funds and one index fund, employees tilt their contributions toward actively managed funds. The larger number of active offerings is seen as a tacit endorsement by their employer, and so drives how many employees divvy up their contributions. What to do? The adoption of target-date funds has helped employees allocate their savings more rationally.
Endowment effect. We tend to value what we own more highly than others might because parting with it feels like a loss. Hanging on to Grandma’s Limoges figurines will cause little harm. But unflagging loyalty to faltering companies, such as Eastman Kodak or Bethlehem Steel, can decimate a portfolio.
Home country bias. At a time when Australian companies made up 3.5% of global stock market value, Australian stock investors, on average, held more than 73% of their money in Australian shares. Investors everywhere prefer to invest in familiar companies from their own country. This usually means we’re underweight foreign shares, which reduces diversification and increases risk.
House money bias. People feel freer to spend money from a successful investment, inheritance or lottery than they do with funds earned through work. This “play money” effect is especially pronounced in casinos, where winnings are more easily risked, despite the fact that $100 is worth $100, no matter how it arrived in our purse or wallet.
Loss aversion. We tend to feel the pain of loss roughly twice as acutely as the pleasure of gain, making investors reluctant to sell losing positions because they must confront the pain of loss. Often, the wiser course is to sell losing positions quickly and without remorse, while letting winning positions run by holding onto them—and yet people tend to do the opposite.
Mental accounting. People segregate their money by its purpose. In reality, all money is fungible, which means it’s interchangeable. Mental accounting can help people reach their goals by making the money set aside for, say, the kids’ college costs seem inaccessible for the parents’ Caribbean vacation.
Overconfidence. Humans possess a healthy amount of optimism even when it isn’t justified. When told that 80% of new restaurants fail within five years, optimistic entrepreneurs often explain why this doesn’t apply to their situation “because.”
Planning fallacy. When undertaking a project, we imagine only clear sailing. We don’t make allowances for price increases, late deliveries, bad weather, builders’ errors or permit delays. As a result, everything from kitchen remodels to airport expansions take longer and cost more than anticipated.
Recency. This is the belief that recent conditions will persist. People buy stocks when they’ve been going up and valuations are already high. After a bear market, they balk at buying shares at lower valuations because they expect the price slide to continue. Money flows into mutual funds often go “the wrong way,” as people—in aggregate—buy at high prices and sell after a sharp drop.
Salience. Our attention is drawn to what’s novel or dramatic. Seeing someone claim a $100 million Powerball jackpot on TV plants the idea that we, too, might win. The cost of a taxi ride seems high because the meter is clicking away. By contrast, the cost of car ownership—gas, insurance, repairs, loan payments—may not feel as great because it goes unquantified.
Sunk cost fallacy. People sometimes add more money to losing positions in hopes of a turnaround. The first money is “sunk” or gone. Adding more funds may make the eventual loss worse, and yet a farmer or factory owner may drain away a lifetime of profits to keep a declining enterprise going. Ditto for desperate gamblers, who may bet the ranch on a final hand to try to recoup their losses. A wiser strategy: Weigh each investment or bet on its own merits.
Greg Spears is HumbleDollar’s deputy editor. Earlier in his career, he worked as a reporter for the Knight Ridder Washington Bureau and Kiplinger’s Personal Finance magazine. After leaving journalism, Greg spent 23 years as a senior editor at Vanguard Group on the 401(k) side, where he implored people to save more for retirement. He currently teaches behavioral economics at St. Joseph’s University in Philadelphia as an adjunct professor. The subject helps shed light on why so many Americans save less than they might. Greg is also a Certified Financial Planner certificate holder. Check out his earlier articles.