It’s not hard to create an alphabetical list of financial behavioral biases, there are so many of them to speak of. Today, we’ll go on with our discussion of the more significant ones with: hindsight, loss aversion, mental accounting, and outcome bias.
Hindsight
What is it? In Thinking, Fast and Slow, Nobel laureate Daniel Kahneman shares how he learned about the “I knew it all along” effect when he was still a student. This is the mistaken belief that our memory is valid even when it isn’t. For example, your team might lose the Super Bowl, even when you’ve been rooting for them the whole time. Later as you think through the game, you may be convinced that you saw the outcome the whole time—you remember making conclusions and having insights that you never really had.
When is it helpful? Hindsight bias can help us to have a more comforting, positive outlook, similar to blind spot bias, which we discussed in previous articles. In Why Smart People Make Big Money Mistakes, Belsky and Gilovich assert that “We humans have developed sneaky habits to look back on ourselves in pride.” Sometimes this helps us to make it over hurdles and take chances with positive outcomes.
When is it harmful? When hindsight bias influences our scrutiny of the market or results of our portfolio. Kahneman writes that this bias, “leads observers to assess the quality of a decision not by whether the process was sound but by whether its outcome was good or bad.” If we play a high-risk investment and win once or twice, we may forget how risky it actually was and bet too much and too fast in the future. On the other hand, some of us tend to “leave the table” too quickly and miss out if an investment isn’t paying off right away.
Loss Aversion
What is it? The fact is that we often fear losing more than we want to win, and this can affect the way we balance risks and reward. In “Stumbling on Happiness,” Daniel Gilbert points out that most of us would refuse a bet that gives us an 85 percent chance of doubling our life savings and a 15 percent chance of losing it. The odds might be overwhelming in favor of winning, but the aversion to loss is powerful enough to keep us from making the bet.
When is it helpful? Loss aversion may be partly responsible for our decision to get insurance. The impulse of loss aversion says that unlikely doesn’t mean impossible so protecting against disaster can make sense when we consider how difficult recovery can be.
When is it harmful? Loss aversion can tell us to cash in as soon as the market looks shaky or when we have the slightest intimation that a down trend is coming. Evidence may indicate that higher rewards may come from taking a long-term view of our investments. Yet just the potential of loss can knock us off the path toward our long-term financial goals when we make investment decisions based on loss aversion.
Mental Accounting
What is it? When fifty dollars from your grandparents feels different than fifty dollars you won playing bingo—that’s mental accounting at work. Though the dollar amounts are the same, we will treat the money we were given different from money that we won by luck. This emotional context influences our mental accounting.
When is it helpful? In “Mental Accounting Matters,” Nobel laureate Richard Thaler (who coined the term), writes that we use this impulse “to keep track of where [our] money is going, and to keep spending under control.” If we set aside $200/month for date night with our partner, we are more likely to use that allotment for its purpose and not to overspend. The significance of the label attached to the money keeps our attention.
When is it harmful? Mental accounting may help us keep money, but will not always help us make money. If you inherited some stock, you will have an emotional attachment to it. Even if the stock plays poorly, you may not cash in because of this mental accounting, and lose sight of long-term outcomes.
Outcome Bias
What is it? Sometimes outcomes match up with research and wisdom and sometimes they are plain blind luck. Outcome bias occurs when we see random positive outcomes as a result of our own acumen.
When is it helpful? This bias is probably never helpful in the long run. It’s vital to know the difference between outcomes of luck and skill so that we can improve and sharpen.
When is it harmful? In “Thinking, Fast and Slow,” Kahneman writes that outcome bias “makes it almost impossible to evaluate a decision properly – in terms of the beliefs that were reasonable when the decision was made.” When this bias is at work, we can be overly critical of a wise decision if the results happen to disappoint. On the other side, this bias can make for a “halo effect,” giving credit to “irresponsible risk seekers …who took a crazy gamble and won” out of sheer chance. The more someone makes it on lucky bets, the more they are tempted to follow luck and intuition rather than research and wisdom.
We’ve made it past the halfway point on our alphabetical list of financial biases! Contact us for strategies tailored to your financial goals and stay tuned for our next installment.
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