You are your own worst enemy.
Those are the six most important words in investing. Shady financial advisors and incompetent CEOs don’t harm your returns a fraction of the amount your own behavior does.
Here are 15 cognitive biases that cause people to do dumb things with their money.
1. Normalcy bias
Assuming that because something has never happened before, it won’t (or can’t) happen in the future. Everything that has ever happened in history was “unprecedented” at one time. The Great Depression. The crash of 1987. Enron. Wall Street bailouts. All of these events had never happened… until they did. When Warren Buffett announced he was looking for candidates to replace him at Berkshire Hathaway Inc. (NYSE:BRK.B), he said he needed “someone genetically programmed to recognize and avoid serious risks, including those never before encountered.“ Someone who understands normalcy bias, in other words.
2. Dunning-Kruger effect
Being so bad at a task that you lack the capacity to realize how bad you are. Markus Glaser and Martin Weber of the University of Mannheim showed that investors who earn the lowest returns are the worst at judging their own returns. They had literally no idea how bad they were. “The correlation between self-ratings and actual performance is not distinguishable from zero” they wrote.
3. Attentional bias
Falsely thinking two events are correlated when they are random, but you just happen to be paying more attention to them. After stocks plunged 4% in November 1991, Investor’s Business Daily blamed a failed biotech bill in the House of Representatives, while The Financial Times blamed geopolitical tension in Russia. The “cause” of the crash was whatever the editor happened to be paying attention to that day.
4. Bandwagon effect
Believing something is true only because other people think it is. Whether politicians or stocks, people like being associated with things that are winning, so winners build momentum not because they deserve it, but because they’re winning. This is the foundation of all asset bubbles.
5. Impact bias
Overestimating how big of an impact an event will have on your emotions. Most people are utterly terrible at predicting how happy they’ll be after receiving a raise, or getting a new job, particularly as time goes on. We get used to more (or less) money quickly, but it’s extremely difficult to realize that before it happens. Your financial goals might change after coming to terms with this.
6. Frequency illusion
Once you notice an event, it seems to keep happening over and over. But it’s often not; you’re just paying more attention to something you were once oblivious to. The 2008-09 market crash was such a memorable event that I think investors and the media became infatuated with today’s “volatile market.” But the last three years have actually had below-average market volatility. We’re just more attuned to normal market swings than usual.
7. Clustering illusion
Thinking you’ve found a pattern by taking a small sample out of a much larger one. For example, we know stocks’ daily movements over time are random and unpredictable, but you could take a four-day period where a stock went up, up, down, down, and think you’ve found a trend. Day traders are attracted to clustering like bugs to bright lights.
8. Status quo bias
Irrationally wanting things to stay the same. People do this in part because they want to avoid costs even when they’re offset by a larger gain — a process psychologists call “loss aversion.” You stick with the same bank even though it charges higher fees than another. You hold onto a stock you inherited even when you know little about it. You don’t make changes to your portfolio even when it’s not designed for your goals. You just want things to stay the same — a dangerous mind-set in a world that’s always changing.
9. Belief bias
Accepting or rejecting an argument based on how well it fits your pre-defined beliefs, rather than the objective facts of the situation. Pointing out that inflation has been low for the last five years is still met with suspicion by those who believe the Federal Reserve’s actions must be causing hyperinflation.
