When it comes to money management, more often than not, emotions dominate logic. Our rational mind is hijacked by behavioural biases. And this can cause us to make rash decisions that lead to significant losses and regret. Today, I’d like to discuss this with you: 3 cognitive biases that can cripple your decision-making process and that can cost you money. As you read further, take a moment to observe how often you give into your emotions and let these biases prevail.
Anchoring bias
What do you think is the approximate price of bitcoin today? Do you think the price is higher than ₹12 lacs, or lower?
Unless you’ve been keeping a close watch, you might have guessed the price to be say, ₹11 lacs or ₹13 lacs, somewhere close to the first number you saw. But the actual price of bitcoin is almost ₹36 lacs!
When we anchor onto the first piece of information we receive, it is known as Anchoring Bias. This bias can skew our financial decisions as well. And it almost always does.
Let me share something from my own life. Recently, I had been looking to buy a wedding outfit. The first few shops that my mom and I went to had lehengas ranging from ₹75,000 to ₹1,00,000. Outrageous, isn’t it?! And then we stumbled upon a store that had outfits worth ₹50,000.
Having started my lehenga quest with prices ranging from 75k to 1 lac, somehow, 50k felt reasonable. What’s more is, my mom also commented, “Oh, that’s cheap.” That shocked me! It really is not that cheap, when all my life I have never spent even a tenth of that on a single item of clothing. But because we anchored onto the first price, this seemed better. The problem is that we were unaware of the average price for this something like a wedding lehenga.
The best way to avoid this bias is to research more. Talk to people around you if you like, just to get a better idea. Do your research, but DO NOT anchor on the first piece of information that you get.
Loss aversion
Say you find ₹200 in an old pair of jeans one morning. Later in the day, you happen to lose ₹100. You are sure to feel the pinch of losing a hundred rupee, despite having only just found this “gift-out-of-the-blue” money. The pain of a loss is always more than the joy of a win.
Let’s take another case. Say you had invested ₹5,000 in equity shares of a company a year ago. Today you sold the whole lot at ₹10,000. That’s a 100% gain! But wait, there’s more. The next day, the markets soar, and the value of this investment, had you waited a day, would have been ₹14,000. This additional 4k is a notional loss. And surprisingly, the pain of this notional loss can often-times be more than the overall gain you actually made. This is just how our minds work.
Human behaviour is hardwired to be loss averse since the beginning of time.
“For an organism operating close to the edge of survival, the loss of a day’s food could cause death, whereas the gain of an extra day’s food would not cause an extra day of life (unless the food could be easily and effectively stored).”
Wikipedia
When it comes to money management, be aware of the loss aversion bias, as this could be a terrible weakness. It’s important to be objective. And to learn to cut losses – in life as well as with your investments.
Confirmation bias
The most common cognitive bias is confirmation bias. We are always trying to validate our beliefs or ideas.
For instance, if you have heard a lot about how great equity trading is, and plan to do it, you’ll constantly seek positive feedback on that idea. Instead of asking neutral questions like, “What are the pros and cons of trading?”, you’ll ask questions like, “What are the benefits of equity trading?”
In other words, you decide first and then look for data to support your views. This could lead to taking unfavourable risks when it comes to investing.
Overcoming these biases
Observe how you make decisions. Are you being overly emotional about things and spending unnecessarily? Or are you being reasonable; certain that your decision is unaffected by these biases? You alone are the best judge of this.
The source of any bias is ignorance. Be it ignorance that you might be biased in a given situation, or that you’re ignorant about what you’re dealing with. And ignorance is not always bliss. As musician, Daryl Davis says, “You fix the ignorance, there’s nothing to fear.”
