When it comes to managing money, most of us believe we’re making rational decisions. However, research shows that our brains are hardwired with cognitive biases that often lead us astray. These mental shortcuts, or biases, affect how we interpret information, make decisions, and ultimately manage our finances. From overconfidence to herd mentality, these biases shape our relationship with money in ways we don’t always notice.

Morgan Housel’s The Psychology of Money delves into the many ways cognitive biases impact our financial behaviour. By understanding how these biases work, we can take steps to mitigate their effects and make better financial decisions.

1. Overconfidence: The Dangerous Illusion of Control

Overconfidence is one of the most pervasive cognitive biases in financial decision-making. Many investors believe they can predict market movements or outsmart professional fund managers, despite evidence to the contrary. A study published in the Journal of Economic Behavior & Organization found that overconfident investors tend to trade more frequently, often leading to lower overall returns. In fact, frequent traders earned annual returns that were 6.5% lower than those of buy-and-hold investors.

The Dalbar Inc. study on investor behaviour echoes this, revealing that the average equity investor significantly underperforms the market, largely due to overconfidence and excessive trading. While the S&P 500 delivered an average annual return of 10% over a 30-year period, the average investor earned only 7.7%, largely due to overestimating their ability to time the market.

Housel emphasises that humility, rather than overconfidence, is a critical trait for long-term financial success. Accepting that you don’t have complete control over the market, and that luck plays a bigger role than most people realise, can help curb overconfidence and lead to better decision-making.

2. Loss Aversion: Why We Fear Losing More Than We Love Gaining

One of the most well-documented cognitive biases is loss aversion—the tendency to feel the pain of losses more acutely than the pleasure of equivalent gains. Nobel laureates Daniel Kahneman and Amos Tversky were the first to explore this phenomenon, showing that people typically experience twice the emotional impact from losing £100 compared to gaining the same amount.

Loss aversion often leads investors to hold onto losing investments for too long, hoping they will recover, rather than cutting their losses. It also drives many people to avoid taking necessary financial risks, such as investing in the stock market, for fear of losing money.

The Financial Conduct Authority (FCA) found that nearly 40% of UK adults hold their savings in cash rather than investing in stocks or bonds. This is despite the fact that cash holdings lose value over time due to inflation. The emotional discomfort of potential market losses outweighs the logical benefits of investing for many individuals.

3. Herd Mentality: Following the Crowd

Humans are social creatures, and this extends to our financial decisions. Herd mentality occurs when people make investment decisions based on what others are doing rather than conducting their own research. This bias explains why speculative bubbles form and why people often buy high and sell low.

The 2000-2002 Dotcom Bubble and the 2008 Housing Crisis are prime examples of herd mentality in action. During both events, masses of investors rushed into booming markets, only to experience devastating losses when those bubbles burst. According to a study by Yale University, investors who followed the crowd during these bubbles underperformed by 4-6% annually compared to those who maintained a disciplined, long-term approach.

Morgan Housel stresses the importance of independent thinking in finance. Following the crowd might feel safe in the moment, but it often leads to poor outcomes in the long run.

4. Anchoring: Sticking to Irrelevant Information

Anchoring is a bias where individuals rely too heavily on an initial piece of information when making decisions. This is particularly dangerous in finance, where irrelevant or outdated data can affect critical decisions. For instance, when buying a stock, investors might fixate on its past high price, using it as an anchor, even though it has no bearing on the stock’s future potential.

A report from The Behavioral Finance Institute found that investors who anchor on past stock prices or benchmarks tend to make suboptimal investment decisions. This leads to irrational expectations and missed opportunities.

Conclusion: How to Overcome Cognitive Biases

While cognitive biases are deeply ingrained in human psychology, they don’t have to dictate your financial future. The first step to overcoming these biases is recognising when they are influencing your decisions. From there, you can implement strategies to counteract their effects.

Automated investing, for example, helps eliminate biases like loss aversion and overconfidence by removing emotional decision-making from the process. Diversification can also protect against herd mentality and anchoring, ensuring that your portfolio isn’t overly exposed to any one asset or market.

By being aware of cognitive biases and adjusting your financial strategy accordingly, you can make better decisions that will help you build lasting wealth.

References:

• Housel, Morgan. The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness. Harriman House, 2020.

• Kahneman, Daniel, and Amos Tversky. Prospect Theory: An Analysis of Decision under Risk. Econometrica, 1979.

• Dalbar, Inc. “Quantitative Analysis of Investor Behavior,” 2020.

• Financial Conduct Authority (FCA), “Cash Savings and Inflation,” 2021.

• Yale University, “The Impact of Herd Mentality on Investment Bubbles,” 2018.

• The Behavioral Finance Institute, “Anchoring Bias in Investment Decisions,” 2019.

• Journal of Economic Behavior & Organization, “Overconfidence and Excessive Trading,” 2017.