Researchers call them prejudices, although we know them as beliefs, often deeply held and, over time, ruining our financial lives.
A team of behavioral researchers from Morningstar, using data from a University of Chicago survey, quantified how four biases lead people to have less savings, more debt, and lower credit scores . Based on the survey responses, 1,200 participants were classified into three categories: financially vulnerable, financially able to adjust, or in good health.
Do any of them sound familiar to you?
LOSS AVERSION BIAS: When an investment falls below what we paid, we tend, rather than carefully reassessing whether it remains a viable investment (or not), to tell ourselves: purchase price . “What makes you think it’s going to bounce back? People with loss aversion bias were 1.33 times more likely to be in the vulnerable group than those with lower loss aversion .
CONFIDENCE SURPLUS BIAS: We are often convinced that we are smarter than we are. Although decades of data have shown that most professional fund managers don’t beat the market, billions of dollars remain invested in actively managed mutual funds. It is overconfidence for most of us to believe that we have better information than others. The researchers found that people who had a high level of overconfidence were 2.2 times more likely to land in the vulnerable group and 3.33 times less likely to save for retirement.
CURRENT BIAS: Deferred gratification isn’t easy. A dollar spent today on something that gives us pleasure is so much more appealing than putting that dollar in a retirement account that we won’t use for decades. Those who struggle the most with the current bias were 1.97 times more likely to be in the vulnerable group. People with low present bias, however, are 7.5 times more likely to plan for the future.
BASE RATE NEGLIGENCE BIAS: We may be swept away by new information that requires us to make a decision that we would not otherwise make if we carefully consider the likelihood that this information is correct or useful. Participants in the bucket of a high level of neglect at the base rate were 1.75 times more likely to be financially vulnerable.
How to overcome your financial biases
Automate your savings. Whether it’s an emergency fund or a retirement account, the best way to get around the current bias is to set up automatic direct deposits into these accounts.
Limit your risky behavior. Cut out a small slice of your overall investment pie for day trading or an unfounded bet. If 90-95% of your money relies on well-diversified funds or exchange-traded funds for your long-term goals, and you give yourself 5 or 10% just to see how smart you really are, that’s still a very good win.
Slow down. When you have an idea to do something, make yourself wait a few days. Letting the adrenaline around a decision flow a bit helps us make a more lucid decision. And if it’s a really big decision, you owe it to yourself to spend that time thinking about whether you are making a factual decision or an emotionally satisfying decision. When it comes to your money, a double bias check can be the difference between financial health and a very vulnerable life.
Hire a behavioral bias watchdog. If you can relate too much to these costly biases and aren’t sure you have the discipline to be less under their influence, working with a financial planner can be a worthwhile investment. A good advisor will definitely focus on what will work for you in the long run and push you to plan for the long term.
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