4: Self-Inflicted Pitfalls: The Dangers of Psychological Biases

Why do generally sensible people sometimes make foolish decisions involving money and investing? A major reason is that they have psychological biases and make predictable cognitive errors. These problems are inherent in everyone’s thinking process, but some people are more susceptible than others to their influence. Knowledge and experience help to reduce the influence of behavioral biases on financial decisions. This chapter is intended to help give you that knowledge by informing you about these self-inflicted pitfalls and how to avoid them.

Behavioral biases occur for several reasons. These problems come from limitations in such areas as memory, attention, knowledge, and time. Various cognitive errors occur because the human brain is subject to these limitations. When the thinking process attempts to simplify its information processing, it often creates predictable biases in the judgments. Investing decisions are particularly vulnerable to behavioral biases because they involve much uncertainty. Since investors don’t know what will happen in the future, they lack all of the information needed when analyzing investment choices. Without having the necessary information, the cognitive process must “fill in the gaps” to reach a conclusion. In other words, your brain takes a shortcut. This mental shortcut, also called heuristic simplification, helps in forming judgments, but also has inherent biases that are problematic for financial decision making.