3 Biases That Mess Up Your Finances

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blind spotWe all have biases. From politics to the way we view our own upbringing as “normal,” there are biases in our lives. And they affect more than just what they believe. They can also affect our behavior, and how we handle our finances.

Recognizing your biases is the first step toward overcoming them. This is particularly important if you want to keep your own biases from messing up your finances. If you aren’t careful, the things that you think are true can mess you over big time:

1. Confirmation Bias

In psychology, confirmation bias is when you choose to focus on information that agrees with what you already believe. So, you tune out information that doesn’t agree with a decision you have already made. Instead, you seek confirmation for you decision, and cherry-pick the stuff that seems to support what you want to believe. (Related to this is the backfire effect, in which you reject information that contradicts you — even if, at some level, you know it to be true.)

This can be dangerous when making financial decisions. It can mean that you stick with a flawed debt reduction plan because it’s easier for you — even though there is information out there that points to a better way. With investing, confirmation bias can lead you to hold on to a stock long after you should have cut your losses and moved on, since you are right, dammit, and there is some small information out there indicating that the stock will turn around. Unfortunately, this can lead to even bigger losses down the road.

2. Attentional Bias

My husband, the Psychology Ph.D., is constantly calling me out for this bias. With attentional bias, you focus your attention on only two outcomes. Sometimes, I get into a very either-or mindset, and my husband tries to get me to think in terms of a range of options. When it comes to your finances, getting stuck in that rut, where you only see two possible outcomes, can be a problem. You become so focused on the either-or that you ignore other solutions to your problem.

One thing I see frequently is this idea that you have to cut your spending to the bone, pinching every possible penny, or be in debt forever. Many people completely ignore a slower debt pay down process. But even more depressing than that is the fact that the attentional bias is so strong that they don’t realize that one alternative is to make more money. When you find yourself stuck between two options, stop and break out of that thinking. Cast about for more creative solutions, and you’ll have more room to maneuver in your finances.

3. Bandwagon Bias

From Warren Buffett, we learn to break out of this bias, and get greedy when others are afraid, and be afraid when others are getting greedy. The bandwagon bias is when we do the same thing because everyone else is. Everyone else thinks a bigger house is better, so you decide to buy the biggest house you can, rather than sticking with something smaller. There’s a huge panic, so you unload your stocks for no good reason, even though they are fundamentally sound and you’re taking a loss.

Before you follow the crowd, stop and think about what you’re doing. You don’t want to let your biases get in the way of a better financial situation.

(Photo: nimishgogri)

{ 5 comments, please add your thoughts now! }

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5 Responses to “3 Biases That Mess Up Your Finances”

  1. Great advice! The confirmation bias is a bias that is definitely difficult to overcome for most people. It is easy to tune out information.

  2. admiral58 says:

    The thought of being wrong is def. a huge bias I have regarding investments.

  3. This awesome stuff!! Sounds like you have a fountain of wisdom living with you. 🙂

    There are other tendencies and biases, I’m sure. One tendency I notice is to not want to sell a stock I bought when it drops in price. Logic says cut your losses, but I find that almost seems tantamount to admitting failure or defeat, so I’m always tempted to hold on the loser stock in hopes that it will come back up again and vindicate me and my stock picking. Is there a name for that?

  4. Shirley says:

    William, does this fit?

    (Related to this is the backfire effect, in which you reject information that contradicts you — even if, at some level, you know it to be true.)
    See ‘Confirmation Bias’

  5. Christine says:

    William, look up sunk cost fallacy. 🙂

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