His “really, really good deal” turned out to cost $72 more than he would have paid for the same number of Aussie dollars if he’d pulled off SH20 en route to the airport for one minute to visit a Lotus Foreign Exchange shop or similar establishment. His blustering when challenged was a classic representation of the confirmation bias that comes out whenever someone wants to justify a less-than-stellar financial decision.
Because the transaction was “fee-free”, this guy convinced himself he’d snagged himself a great deal. The poor exchange rate cost him.
So, is confirmation bias the worst financial bias known to man (and woman)? No, says just about everyone I’ve spoken to. We do much worse stuff when it comes to our money.
For Ananish Chaudhuri, a professor of experimental economics at the University of Auckland, that winning bias, at least inversely for our finances, is present bias, which is about living for the present and manifests in the inability to delay gratification. “I am choosing to settle for a smaller-sooner reward than a larger-later reward.” Someone falling for present bias may also use confirmation bias to support the decision not to delay gratification, says Chaudhuri.
Kernel’s chief operating officer Stephen Upton disagreed with me as well. For him, the killer bias for our finances is the illusion of control, which traders often succumb to.
This is a bias in which people tend to overestimate the power of control they have over circumstances. They think, for example, by choosing their lottery numbers, as opposed to using randomly generated numbers, that they’re more likely to win. Traders who succumb to the illusion of control may use superstitious or pseudo-scientific beliefs, AKA mental shortcuts, to make investment decisions. The illusion of control causes people to trade more often than they should, favour local investments over international ones and under-diversify.
After considering the evils of the illusion of control and the bias of mental accounting, Harbour Asset Management director Chris Di Leva settled on loss aversion as being the worst behaviour bias for our finances. Loss aversion in behavioural economics refers to a phenomenon where a real or potential loss is perceived by individuals as psychologically or emotionally more severe than an equivalent gain. For instance, the pain of losing $100 is often far greater than the joy gained in finding the same amount.
“Loss aversion is a bias we tend to see a lot of in action,” says Di Leva. He cites the example of outflows from KiwiSaver in the early months of 2020, thanks in part to people reading too much news. They wanted to avert losses by getting out of growth funds, but did exactly the opposite. “My old saying is: ‘By the time it is in the news, it is in the price’.”
There are some real humdingers of cognitive biases. There is a great list of biases at Thedecisionlab.com/biases.
Mental accounting makes us put money in different mental buckets according to how it was earned. It lets us spend bonuses frivolously, instead of paying bills, or hive money into low-interest savings accounts instead of paying down high-interest debt.
The Dunning-Kruger effect catches people. It’s where people’s lack of knowledge and skills cause them to overestimate their own competence.
Some of the best defences to the failings of the human brain include understanding how these biases work. Other useful tips include:
- Seeking out a variety of views and actually listening to them;
- Understanding the fundamental drivers of investments, especially flash new ones;
- Having realistic timeframes for investment returns;
- Considering downside risks;
- Taking advice from financial professionals.
Above all, never invest more in a single investment than you can afford to lose.
