Category Archives: Behavioral Econ/Finance

Behavioral Biases Affect All of Our Decisions

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I’ve written a couple of articles for the local paper over the last couple years (the finance department takes turns writing a weekly column) and this week, it’s my turn again. Usually, my articles focus on the behavioral side of finance, though with the election upon us, it seems a good opportunity to illustrate that behavioral biases affect all kinds of decisions. The article is set to run this Sunday, November 4.

I’ve used this space before discussing how behavioral biases lead to making suboptimal investment choices. By increasing awareness of these issues, I hope we make better financial decisions. Our biases affect other decisions, too; with an election coming up in just a couple days, this is a good opportunity to pause and reflect on how we process information and improve our decision making. Evaluating evidence and setting opinions on a particular topic is mentally taxing, but it’s worth taking the time to do it right.

We like to hear that our opinions are right, while reducing the effort required evaluating new information. When we buy a share of stock, we love seeing confirmation that our decision was smart (analysts say the stock remains undervalued…YES!), while dismissing or rationalizing evidence that our play was poor (this analyst knows nothing…it’ll bounce back). This confirmation bias shows up in politics, too.

We search for information that reinforces what we already believe, while reducing exposure to sources that cause us to rethink our positions. Worse, we actively dismiss contrary evidence, too. Conservatives are more likely to watch Fox News than MSNBC (and vice versa for liberals), because we like hearing evidence that confirms our existing beliefs. It requires less mental effort hearing what already agrees with us than reevaluating our positions in the face of new evidence. Ultimately, we’re likely gathering information in a biased way, leading us towards greater polarization.

If you’ve ever tried convincing family that their beliefs are wrong, you’ve probably seen them settle into a more entrenched, less convincible position–the backfire effect in action. This bias causes people to reject evidence that contradicts an individual’s beliefs and pushes them further towards their own initial positions. That is, not only is it very difficult to sway someone, it’s hard not to push them farther away from your position!

This is particularly frustrating when a belief hinges on a falsehood. Research finds that people are more likely to trust a statement, even a false one, if they’ve heard it before—a familiar claim, regardless of validity, is more trustworthy than an unfamiliar statement. Even if it’s factually wrong, if it’s repeated often enough, people tend to think it’s right. You don’t have to know whether something is valid—instead, just hearing something often makes us more likely to believe it.

It’s hard to expose a well-cited falsehood and change minds. And because we seek out confirming evidence of our pre-existing beliefs, we avoid and dismiss contrary evidence. Even when presented with valid, contrary evidence, we frequently become even more entrenched in our existing beliefs! Our minds play lots of tricks on us, limiting our ability to process information efficiently and accurately.

This weekend, spend an extra moment revisiting your positions. Find contrary evidence and consider the validity of new information. With family gatherings, beware the backfire effect—remember it’s tough to convince someone unless they’re ready to be swayed and you’d probably prefer not to push them even farther away.

Overconfident Investing Is Bad For Your Financial Future

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Fifteen months ago, I was asked to write a short article for the local newspaper. At the time I wrote it, I thought it was for the school newspaper. After it was published, I found out that I’d written it for the local newspaper, so I suppose it had a slightly broader audience. Apparently, the department takes turns writing articles for the paper. It’s my turn and below is what I drafted on the spur of the moment this evening (as I’d forgotten that the due date was noon today).

There’s a field of economic research—behavioral economics—where psychology plays a major role in developing ideas about how and why people behave the way they do. We’re learning some fascinating insights into how people act in ways that upend our beliefs of human rationality. I’ll show you a couple of examples of how our behavioral tendencies cause us to act irrationally, even in the realm of finance, and offer up a couple of suggestions for how to overcome our inherent rational shortcomings.

A common example of a behavioral bias is people’s tendency for overconfidence. I’m sure you know someone who has unrealistically positive views of their own skills, knowledge and abilities. That might even describe you. For example, how would you answer the following questions:

“Are you a good driver? Compared to other drivers you see on the road, are you above average, average, or below average?”

One study noted that 82% of sampled college students rated themselves above average! Obviously, many are wrong because they are overconfident in their skills. While being overconfident behind the wheel might not significantly impact your daily life, similar overconfidence issues can affect many things, including your financial future.

Moreover, this is not only a characteristic of the young. It’s commonly understood that most new businesses fail; yet when surveyed about their chances, many new business owners thought they had a 70% chance of success, and only 39% thought any business like theirs would be as likely to succeed!

Perhaps unsurprisingly, this overconfidence stretches even into the stock market. People who are overconfident tend to trade more actively in their investment accounts. Men tend to feel more overconfident in their ability to make investment decisions than women, resulting in more frequent trading and higher turnover for male investors than female. An examination of trading patterns of 39,000 household brokerage accounts noted that men (and single men particularly) were much more likely to trade and had 50% more turnover in their investment holdings than women, resulting in much higher expenses and significantly lower net returns.

Furthermore, overconfident investors believe they are better evaluators of new information and trade more aggressively. Except that they’re not usually as good as they think…the research on these more active traders indicates that they often pick the underperforming stocks. To quote a recent book on it, “Overconfidence-based trading is hazardous when it comes to accumulating wealth.”

If there’s a takeaway from the behavioral finance research I teach, it’s that we’re not as good at stock picking as we want to believe. It’s probably worth remembering that before pulling the trigger on the next stock tip you hear. Instead, we should usually invest in broad market index funds and do so for the long haul. That’s one way to avoid making overconfident trading decisions. Finally, it’s worth remembering that while behavioral biases are present in a vast range of our daily decisions, knowing how they impact our actions can help us overcome them.

Money ≠ Happiness

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How happy would you be working for $75,000 a year?  I imagine that as you embark on a career in a few months or years, you’d be delighted to earn that kind of money doing something you liked.  I also imagine that as you look into the future, you have hopes and dreams of earning a six-figure salary, too.  How happy do you think you’d be if you earned $150,000?  Twice as happy as you were earning $75k?  A new, fascinating area of research explores how happy people are on different subjects, including personal finance, and the results might surprise you.

A lot of happiness research confirms what we already know – earning enough income to satisfy basic necessities – a nice home, worry-free transportation, comfortable retirement savings, and good schooling for your children – is very important to personal happiness.  So is having enough extra money for a vacation or two each year, some nice stuff, and a little extra for flexibility and emergencies.  How happy do you think you’d be if you had all that?  Unsurprisingly, surveys conducted asking people about their levels of happiness show that people who earn about $75k a year are pretty happy, as they have enough income to satisfy all of their basic needs, with a little extra left over for fun.

You might be thinking, “That’s great, but I’d be twice as happy if I earn $150,000.”  Too often, we think that the best jobs are the ones that pay the most.  Survey results don’t agree with you.[1]  People who earn $200k are not happier than people who earn $75k.  That’s a little strange, but we might be able to identify some reasons for this.  Higher paying jobs are often a lot more stressful, which reduces your happiness level.  Maybe you live in a more demanding social network and feel pressure to keep up with peers.  What would you do with the extra money?  Probably one of three things – you could go on more vacations, buy nicer stuff, or put it in savings and retire sooner.

There aren’t a lot of that have the flexibility for more than a couple vacations a year, and while a brand new Mercedes might be a lot nicer than a Honda, would you really get twice as much enjoyment out of a car that’s twice as expensive?  Would you really get a lot more enjoyment out of a top of the line 70” plasma television over a reasonably nice 50” one?  What about retiring early?  If you’ve taken a job that you love, you’re not likely to want early retirement – you like your work.  However, if you hate your job, retiring early doesn’t make up for all those years you dreaded it.

There’s a famous story about an investment banker on vacation in Mexico, enjoying the tranquility of fishing from the pier of a quiet village.  He talks to a local fisherman, who loves the peacefulness of his job and the free time he has to spend with his family, every day of his life.  The banker sees an opportunity to help the fisherman expand his business, build a multi-national fishing empire, become fabulously wealthy, which would enable the fisherman to move from his small house to a huge mansion and a big office to manage his growing empire.  The fisherman asks if it would be very stressful.  The investment banker replies that it would be stressful, but with the high income he could save and retire early, spending his retirement fishing peacefully from the pier of a quiet village and spending lots of time with his family.

These columns offer a lot of advice – don’t borrow too much, save money, spend wisely, etc. – but you should also consider the big picture: there’s much more to life than making money.  As you embark on a new career in the near future, look for work that interest you, is meaningful, and can make you comfortably wealthy – enough to satisfy your basic needs with a little extra for some nice stuff and a little fun.  Maximize your happiness.  All the research suggests that really wealthy people aren’t much happier, so look for jobs that put you on a career track that makes you happy, not necessarily the ones that pay the most – money does not equal happiness.

[1] Kahneman, Daniel and Angus Deaton, 2010, “High Income Improves Evaluation of Life But Not Emotional Well-Being”, Proceedings of the National Academy of Sciences.