10. Curse of knowledge
When educated people can’t comprehend that lesser-educated people think and act differently from them. Financial advisors and journalists fall for this all the time, spouting off lingo and catch phrases without realizing their customers have no idea what they’re talking about (and are too afraid to ask for clarification). This also explains why there’s a wide gap between academic theory and real-world reality. Economists who understand finance wrongly assume lay people will act in their best interests. Wall Street banks rightly assume they won’t.
11. Gambler’s fallacy
The belief that future events will be shaped by past events, even when the two have no correlation. A gambler will assume a coin is due to come up heads after flipping a string of tails, but the outcome of the next flip is completely independent of the last one — the odds are still 50/50 regardless of prior flips. Investors fall for a version of gambler’s fallacy when assuming things like economic data, quarterly earnings, and politics will dictate the direction of the market, when in reality the two often move independent of each other. Randomness is hard to accept.
12. Extreme discounting
Preferring a small but immediate payoff over of a larger payoff down the road. Some discounting is rational, but investors consistently take it to the extreme. People who have decades ahead of them to invest trade in and out of the market to avoid small, short-term losses, almost always at the expense of long-term returns.
13. Ludic fallacy
Coined by Nassim Taleb in The Black Swan, the naive belief that the real world can be predicted with mathematical models and forecasts. It leads people astray because models are purposely simplified while the real world is incomprehensibly complex. As author Dan Gardner says, “No one can foresee the consequences of trivia and accident, and for that reason alone, the future will forever be filled with surprises.” Ninety percent of stock analysts and economists would disappear if we’d all just accept the ludic fallacy.
14. Restraint bias
Overestimating your ability to control impulses. Studies show smokers in the process of quitting overestimate their ability to be say no to a cigarette when tempted. Investors do the same when thinking about the temptation to do something stupid during market bubbles and busts. Most investors I know consider themselves contrarians who want to buy when there’s blood in the streets. But when the blood arrives, they panic just like everyone else.
15. Bias bias
The most important and powerful bias of them all, “bias bias” is the belief that you are less biased than you really are. If you read this article without realizing I’m talking about you, you’re suffering from bias bias.
Everyone is prone to cognitive errors. Some more than others, but no one is exempt. Coming to terms with the idea that you are your own worst enemy is the single most important thing you can do to become a better investor.
Daniel Kahneman, who won the Nobel Prize for his work studying cognitive psychology, once said, “I never felt I was studying the stupidity of mankind in the third person. I always felt I was studying my own mistakes.” When you realize you are as biased as everyone else, you’ve won the game.
Check back every Tuesday and Friday for Morgan Housel’s columns on finance and economics.
The article 15 Biases That Make You Do Dumb Things With Your Money originally appeared on Fool.com and is written by Morgan Housel.
Morgan Housel owns shares of Berkshire Hathaway.The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway.The Motley Fool has a disclosure policy.
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