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3 Cognitive Biases That Cause Us To Make Bad Financial Decisions

Here is why so many investors make simple financial mistakes.

As investors, we strive to make the most rational decisions to maximize the opportunities presented to us in the market. However, there are many times where we subconsciously commit illogical decisions that may affect our financial goals. This is especially true when we are unaware of the type of fallacies or cognitive behavioral biases that we commit. Here are 3 cognitive behavioural biases that may potentially affect your investment decisions.

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# 1 Mental Accounting

Mental Accounting is a phenomenon when a person divides his assets into separate accounts. When a person divides his assets into separate accounts, his financial decisions are affected because he assigns different utility onto them as separate non-transferable accounts. People may gain benefits from this kind of behaviour because it may prevent them from spending it unwisely (e.g. not spending a retirement fund or education fund).

“I shouldn’t touch the money in my retirement fund. I think it’s better to take a loan for my child’s education”

However, such cognitive bias may also affect your financial behaviours negatively. Assuming that you have a $50,000 retirement savings fund that sits in a 1.5% fixed deposit account, and you are in need of $25,000 to pay for your child’s school fees. People who fallaciously commit this cognitive bias will take up a $25,000 loan at a bank for 4.5% instead of using $25,000 from their $50,000 retirement savings.

It does not make sense to incur debts at 4.5% because if you were to use your initial $25,000 from your $50,000, you are only forgoing potential opportunity costs. If you were to take up a loan, you will be paying at least an additional 3.0% per annum. True financial rationality dictates us to treat all of money as fungible and with the same philosophy; we must look at our assets from a helicopter point of view!

# 2 Prospect Theory

According to the Prospect Theory proposed by Kahneman and Tversky, it was found that people are more favourable to perceived gains rather than perceived loss. Therefore, if a person were faced with two equal options, one presented in terms of possible gains and the other in terms of possible loss, people will be more likely to choose the former; this is even when both options achieve the same results. It is postulated that most people will usually choose the former as people are risk adverse by nature and that perceived losses can cause a greater emotional impact.

Consider the following situation where a person is required to choose two options: (1) given $50 straight, and (2) gaining $100 and then losing $50. It has been found that people are more likely to choose the former because gains are observed as more favourable than losing money.

Reducing risk is extremely important and beneficial for any investors. However, there may be times when this sort of cognitive bias affect our financial decisions negatively. Consider the case of the two pitches from two different advisors on the same mutual fund: (1) above average gains over the past 4 years, and (2) above average gains over the past 10 years, but has been declining in recent years. According to the Prospect Theory, people are more likely to choose the first option rather than the second option due to the fact that it is presented favourable despite both having the same results.

“Wow. There is a chance of losing money? I don’t think that’s a good choice anymore…”

This is perhaps the reason why we sell winning stocks prematurely and hold losing stocks too long; we are risk adverse and are not comfortable to perceive ourselves losing money. Therefore, it is important to be cognizant of our financial behaviours and not to allow such fallacies to stand as obstacles for us as we seek to achieve the most optimum results.

# 3 Gambler’s Fallacy

Gambler’s fallacy happens when a person believes that the chance of a random event becomes unlikely to happen following a series of events. Using a fair coin as an example, consider a situation where 13 consecutive coin flips resulted in “tails”. A person is said to have committed the Gambler’s fallacy when he believes the 14th coin flip will have a higher probability of resulting in “heads”. This sort of thinking is considered as a fallacy because the actor displays a flawed understanding of probability. The probability of the next coin flip resulting in heads or tails is still 50%; it is independent from the results of the previous coin flips.

“How is it possible to achieve 14 consecutive coin flips resulting in “tails”?! The next coin flip will definitely result in “heads”!”

It is possible for the Gambler’s Fallacy to affect all types of investors, especially those who make active trading decisions. One example for active traders would be to assume a certain stock price will fall due to its’ positive performance from the previous few days (e.g. we are more susceptible to this kind of thinking in a bad market situation. Therefore, it is important to catch ourselves from committing this kind of cognitive behavioural bias that may affect our finance decisions.

“In such a bad market, how is it possible for the stock to close positively in a consecutive 4 days? It will definitely fall tomorrow!”

Being Aware of Our Financial Behaviors and Cognitive Biases

As humans, we are all susceptible to these cognitive biases. In fact, it is possible that we use these cognitive biases to make (bad) financial decisions and perceive ourselves as being rational. Perhaps the most important element in stopping these kinds of behaviours is awareness. Once we are aware of such phenomenon, we are more likely to stop ourselves from committing such behaviours. Therefore, always remind yourselves on whether you have committed these fallacies before you lock yourself into any major financial decisions such as taking a high interest loan.

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