The 5 Biggest Biases We Fall Victim to
By Morgan Housel
Bruce Schneier, an author who writes about how we perceive danger, gave a great talk at TED recently, outlining five cognitive biases people fall victim to when making decisions about risk.
None of the five were intended to relate to investing, but all of them can teach investors something about the rampant biases we make with our money.
1. We tend to exaggerate spectacular and rare risks and downplay common risks.
In investing: Most recent polls show investors' biggest fears center around inflation and national debt. These might be legitimate risks, but they pale in comparison to a common risk that utterly derails so many people's finances: We don't save enough. Someone who invests their meager and inadequate savings in gold will still have a rough retirement even if inflation takes off.
2. The unknown is perceived to be riskier than the familiar.
In investing: The Flash Crash last May caused untold anxiety. A year later, we're still talking about it posing a serious risk to markets. In reality, though, it was a non-event. The whole thing was over in a few minutes. Most didn't even hear about it until it was over and losses were reversed. What made it scary is that it had never happened before. Meanwhile, the risks posed by the herd mentality of buying high and selling low can be absolutely devastating to long-term wealth -- yet it's culturally acceptable because it's so familiar and prevalent. Anyone who sold stocks in March 2009 and is just now getting back into the market has bludgeoned their portfolio in an irreparable way -- a scar the Flash Crash left on virtually no one.
3. Personified risks are perceived to be riskier than anonymous risks.
In investing: The media are good at blowing risks out of proportion by tying them to personal stories. When markets were sinking last summer, both The New York Times and The Wall Street Journal ran articles with stories of individual investors cashing out and giving up on stocks. They were full of anecdotes like, "Greg Jones has had it with volatility and is done with stocks." Well, good for Greg Jones. What about the other 300 million or so of us? If you looked at the data, there was no evidence individual investors were pulling out of the market in a meaningful way.
4. We underestimate risks in situations we do control, and overestimate risks in situations we don't control.
5. We estimate the probability of something by how easy it is to bring examples to mind.
In investing: There's a constant parade of commentators warning about runaway inflation in the near future, yet few ever discuss how many investors guarantee themselves poor investment results by overpaying investment advisors and mutual funds for products that often amount to index funds. The latter just isn't newsworthy because we've come to expect that all money managers deserve seven-figure paychecks. For many, overpaying investment advisors over the course of a lifetime poses a greater risk to long-term returns than a temporary surge of inflation.
Schneier.com is a personal website. Opinions expressed are not necessarily those of Co3 Systems, Inc.