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Biases That Can (Badly) Hurt Your Personal Finances

Contrary to popular perception, human beings are not as logical or rational as they believe themselves to be.

Many of their decisions are based on emotions and instincts. Facts and figures are often ignored or not given due importance. Consequently, the decisions 'influenced' by deep-seated emotions often lead to either sub-optimal or wrong choices.

In behavioral economics, these irrational tendencies are known as biases (or more accurately 'cognitive biases' i.e. tendency to make choices that do not meet the standards of rationality or good judgment.)

As I have often mentioned, managing money is not about managing money.

Greed, Fear, Envy, Love, Hope often play a key role in our day-to-day money matters.

- Most of your money is in Bank Fixed Deposits, because you FEAR the stock markets. 
- GREED makes you fall prey to fancy schemes that promise to deliver extraordinary returns.
- You hold on to your loss-making shares, in the HOPE to at least recover the losses
- You crave for an iPhone because you ENVY your colleague having one.
- You plan your taxes because you HATE giving money to the Govt.
- You insure yourself as you LOVE your family, and don’t want them to suffer in case of any unfortunate eventuality. 

In short, what seems to be as managing money — investing, borrowing, spending, tax planning, insuring, etc. — is nothing but managing emotions.

Since biases can have serious impact on our financial well-being, it is important to understand them. As Benjamin Haydon correctly observed "Fortunately for serious minds, a bias recognized is a bias sterilized.

Listed below are some of the common biases that affect our financial decision-making.

1. Anchoring: When we base — i.e. anchor — our decision on certain specific information or reference point (which, in many cases, turns out to be incorrect or irrelevant e.g. 52-week high price is wrongly seen as some sort of cap and 52-week low price as some sort of floor).

2. Mental accounting: Where we treat money differently based on some arbitrary and subjective criteria (e.g. salary may be spent judiciously, but annual bonus is splurged recklessly). 

3. Availability Bias: More weightage given to the information easily remembered or that which is readily available (thereby ignoring the more relevant information that is not remembered or not easily available).

4. Herd Mentality: Belief that the crowd is right. If most people are following a certain trend, then it must be right. (Beware! More often than not the crowd is wrong).

5. Confirmation Bias: Seeking or believing in the information that supports our viewpoints and preferences. Facts contrary to our views are (sub-consciously) given less weightage.

6. Loss Aversion: Simply speaking, we hate losing money (that’s why we don’t book losses at the right moment and consequently end up holding worthless shares).

7. Optimism Bias: Overestimating the chances of positive outcome vis-a-vis the negative result. This could makes us take risks beyond our capacity.

8. Recency Effect: Latest events are easy to recall. In the process, the older information even if important may be forgotten and ignored.

Biases are illusions that can seriously affecting financial decision-making.

9. Hindsight Bias: After a certain event has already occurred, we tend to (wrongly) believe that it was obvious and predictable (like the historic crash of Jan 2008; but in 2007 no one had anticipated such a worldwide financial disaster).

10. Authority Bias: Assuming that the information or opinion given by an expert is necessarily true and correct.

11. Endowment Effect: When you value something more just because you own it. You won’t value it as much, if you didn’t own it (people expect higher price when selling something they own, vis-à-vis what they would be willing to pay to buy the same product). 

12. Overconfidence Bias: (This needs no explanation) We often overestimate our ability to do certain things. 

13. Gambler’s fallacy: Suppose you toss a coin nine times and for all the nine tosses you get a ‘heads’. Then, for the 10th toss it appears so natural that most people will predict a ‘tails’. This is called Gambler’s Fallacy. Each toss is independent of the previous tosses. Logically, it makes no difference what has happened in the past. Therefore, for the 10th toss also the probability would be 50:50.

14. Conservatism Bias: It takes time for people to adjust to the new information (that’s why with inflation, companies normally don’t increase the price; instead they reduce the weight of their standard packaging).   

15. Clustering illusion: When we try to extrapolate small patterns on a large sample of random data. 

16. Choice-supportive bias: We often believe that our choices are better than they actually are (people tend to invest more in the funds in their portfolio which are doing well; maybe at the cost of ignoring the better funds that are not in their portfolio). 

17. Money illusion: People don’t appreciate the destructive power of inflation. They focus on the face value, completely ignoring its purchasing power.

From the above it is clear that despite the highly evolved brains, human beings are more emotional than logical.

Logically (pun intended), therefore, if you are good at managing your emotions, you automatically become a good manager of your money.

So what is emotional management? 

Well, emotions are an extremely strong and powerful force. Overcoming and overpowering them is not easy. Very few succeed in such attempts... such as the sants and the mahatmas. 

As such, it would be ‘irrational’ to expect people to remain calm and make rational choices. 

Since we ordinary mortals can’t suppress or conquer them, we have to outsmart them. We have to simply try and minimize the impact of emotions by suitably designing our investment processes.

Note: Read my next post How To Outsmart Behavioural Biases In Money Matters to know more about such investment processes.

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