How Our Brains Cause Us to Lose Money

Eight cognitive biases quietly sabotaging your finances, and what to do about each one

Here is an uncomfortable number. In 2024, the S&P 500 returned roughly 25 per cent. The average equity fund investor captured just 16.5 per cent. According to the annual Dalbar Quantitative Analysis of Investor Behaviour report, this 8.5 percentage-point gap was the second largest in a decade, and investors have now trailed the broad market for 15 consecutive years.

Closer to home, New Zealand's Financial Markets Authority (FMA) documented a similar pattern during the COVID-19 market volatility. KiwiSaver Scheme fund switching surged to 2.7 times the prior year's rate as members rushed to move from growth into conservative funds, often locking in losses at the worst possible moment. Only about 9 per cent switched back in time. The vast majority stayed in low-return funds long after markets recovered.

The explanation in both cases is not fees, bad luck, or a shortage of information. It is behaviour. More precisely, it is a collection of mental shortcuts our brains evolved thousands of years ago to keep us alive on the savannah but which, applied to money, reliably steer us toward the wrong decision at the worst possible moment.

None of us are immune. These biases operate beneath conscious awareness, and even knowing about them is only partial armour. But awareness is the necessary first step. The more familiar you are with how your brain defaults to irrational patterns, the better your chances of catching yourself before the damage is done. If you have ever switched a KiwiSaver Scheme fund after seeing a balance drop, chased last year's top-performing investment, or held onto a losing share because selling would mean "admitting" you were wrong, at least one of the biases below was pulling the strings.

Here are eight of the most costly.

1. Overconfidence: why activity feels like skill

Most of us believe we are above-average decision-makers. The data says otherwise. Surveys consistently find around 70 to 80 per cent of people rate themselves above the median behind the wheel. Since exactly half of all drivers are, by definition, in the bottom half, most of us are wrong.

The same inflated self-assessment carries into money decisions. Overconfident investors trade more frequently, diversify less, and tend to concentrate their holdings in a handful of names they feel certain about. Research from the Financial Industry Regulatory Authority (FINRA) found 64 per cent of investors believe they have a high level of investment knowledge. Yet only about a quarter of actively managed mutual funds outperformed their benchmark over the prior decade. Confidence, it turns out, is no substitute for evidence.

Overconfidence also makes us reluctant to seek advice or revisit earlier conclusions. In New Zealand, this commonly shows up when self-directed investors assume they can outperform a well-diversified managed portfolio by picking a handful of individual shares. Sometimes they can, for a while. But the evidence on long-term wealth building overwhelmingly favours discipline and diversification over conviction and concentration.

What helps

• Stay curious. The more you learn about a subject, the more you appreciate what you do not know. Genuine expertise tends to breed humility, not bravado. ‍
• Slow down. Overconfidence thrives under time pressure. Sleeping on a major financial decision is one of the cheapest forms of insurance available.
• Keep a written record of your investment reasoning. Reviewing old notes is a humbling and instructive habit.

2. Anchoring: the invisible price tag in your head

The first number you see shapes every judgement after it, even when the number is irrelevant. Walk into a clothing store, spot a jacket marked down from $500 to $150, and something in your brain whispers: bargain. But was the jacket ever worth $500? The original price is an anchor, an arbitrary reference point your brain latches onto to judge everything.

The psychologists Daniel Kahneman and Amos Tversky demonstrated the effect with a literal wheel of fortune: a randomly generated number influenced participants' estimates of entirely unrelated quantities. The anchor does not even need to be relevant; it just needs to arrive first.

In New Zealand, anchoring is especially visible in property. Buyers routinely fixate on a property's Rating Valuation (RV) or Capital Value (CV) when negotiating, despite these figures often being years out of date and reflecting mass-appraisal methodology rather than the property's current market value. A home with an RV of $950,000 might be worth $850,000 in a soft market or $1.1 million in a hot one. But the RV sits in the buyer's mind as a "fair price," distorting their judgement in either direction.

Investors do the same with share prices. The price you paid becomes the anchor against which you judge everything, even when the company's circumstances have changed completely.

What helps

• Question your reference point. Ask yourself: am I judging this on its current merits, or am I comparing it to an irrelevant earlier number?
• Seek multiple data points. One price, one valuation, or one opinion is never enough to form a sound judgement.
• When evaluating an investment, focus on what the asset is worth today and what it might reasonably produce in future, not on what you or anyone else paid for it.

3. Confirmation bias: hearing only what you want to hear

We gravitate toward information supporting what we already believe, and filter out anything inconvenient. It feels good to be right, and our brains are wired to protect existing beliefs. In investing, this becomes dangerous the moment you commit money. If you buy shares in a company, you will naturally notice positive news and subconsciously discount warning signs.

Online echo chambers have supercharged this tendency. Algorithmic feeds serve content matching your existing interests, so an investor bullish on a particular sector will keep seeing optimistic takes. The counter-arguments simply never appear. As the CFA Institute's behavioural finance curriculum notes, confirmation bias is one of a family of belief perseverance errors: once a belief takes root, we invest disproportionate effort in protecting it.

In New Zealand, confirmation bias frequently surfaces around property investment. A landlord convinced the housing market will keep rising will seek out articles and conversations confirming the view, while ignoring changes to interest deductibility rules, bright-line tests, or debt-to-income restrictions pointing the other way.

What helps

• Actively seek well-reasoned opposing views. If you are excited about an investment, deliberately search for the best arguments against it.
• Surround yourself with people willing to challenge your thinking. Agreement is pleasant; it is not especially useful for financial decisions.
• Before committing to a big money decision, compare the most likely outcomes of your preferred choice against at least one credible alternative.

4. The bandwagon effect and FOMO: following the crowd off a cliff

Our ancestors survived by sticking with the group. That wiring now costs us money. On the savannah, going along with the tribe meant safety, food, and mates. Solitary operators were more likely to end up as lunch. But what kept your ancestors alive now leads you toward crowded trades and overvalued assets.

The bandwagon effect is what happens when tribal instinct meets modern financial markets. When enough people pile into an asset, the price rises, which draws in more people, which pushes the price higher. Fear Of Missing Out adds urgency. The cryptocurrency booms of recent years provided a vivid demonstration: at the peak, taxi drivers and dinner party guests alike were offering tips on obscure tokens, and the primary argument for buying was everybody else is.

Research suggests as few as five per cent of influential investors can sway the remaining 95 per cent. Herding behaviour consistently amplifies both bubbles and crashes. KiwiSaver Scheme members are not immune: the FMA has documented waves of members switching into growth funds after strong market years, only to panic-switch back to conservative options when volatility returns.

What helps

• Develop a personal investment framework and stick to it. Clear criteria for what you will and will not buy makes it far easier to ignore the noise.
• If someone's pitch boils down to "everyone is doing it," you are hearing a description of a crowd, not an analysis of value.
• The best opportunities in financial history have almost always required acting independently of the consensus.

5. Loss aversion and the disposition effect: why we hold losers and sell winners

Losing $100 feels roughly twice as painful as gaining $100 feels good. This asymmetry shapes almost every financial decision you make. Known as loss aversion, it is one of the most extensively documented findings in behavioural psychology, first formalised by Kahneman and Tversky in their Prospect Theory work.

Our cave-dwelling ancestors had good reason to weigh threats more heavily than opportunities. Missing out on a patch of berries was inconvenient; failing to spot a predator was fatal. The problem is we have inherited this survival circuitry and now apply it to share portfolios.

In finance, loss aversion produces a specific pattern called the disposition effect: investors sell winning positions too early to lock in gains, while holding losing positions far too long in the hope of "getting back to even." The Dalbar data shows the result. In 2024, the average investor's "Guess Right Ratio" for timing fund inflows and outflows fell to just 25 per cent, tying a record low. Three-quarters of the time, investors moved money in the wrong direction. It is hard to build long-term wealth when your instincts push you to do the opposite of what the data suggests.

Closely related is the sunk cost fallacy. A classic 1985 study gave participants two holiday tickets: one costing $100, the other $50 for a better trip. When told the trips overlapped and neither was refundable, over half chose the more expensive but less enjoyable holiday. The money was gone either way, but the brain could not let go of the bigger loss.

This is precisely where objective, professional perspective earns its keep. When emotions cloud judgement, a good adviser acts as a circuit-breaker. Our advisory process is designed with this in mind.

What helps

• Ask the non-owner question: if you did not already own this asset, would you buy it today at its current price? If the answer is no, the rational move is to sell. This applies equally to shares and to physical possessions you no longer use.
• Focus on net outcomes rather than individual wins and losses. A diversified portfolio will always contain some positions going backwards. What matters is the total.
• Separate the current facts and your best prediction of the future from what has happened in the past. Sunk costs are gone; the only question is what to do next.

6. The gambler's fallacy: finding patterns in randomness

A fair coin has a 50/50 chance of heads or tails every single time, no matter what happened before. Your brain disagrees. Imagine a friend flips a coin and gets heads five times running. Surely the next flip must be tails? It feels intuitive, but it is wrong. Past flips have no influence on future flips.

The gambler's fallacy is the mistaken belief patterns in random events can predict future outcomes. Applied to money, it shows up in statements like: "The market has been down three months running, so it must bounce back soon." Or the reverse: "This rally has momentum; it is different this time."

A related error is skipping insurance because nothing bad has happened yet. "I have never had a car accident" is not a statement about probability; it is a description of luck to date.

What helps

• Past performance does not guarantee future results. It applies to coins, share markets, and everything in between.
• Base decisions on current conditions and sound analysis, not on pattern-matching from recent events.
• Be especially wary when you catch yourself, or anyone else, using the phrase "This time it is different."

7. Mental accounting: the invisible buckets costing you money

A dollar is a dollar, no matter where it came from. Yet we treat money from different sources as if it has different value. Behavioural economist Richard Thaler, who won the Nobel Prize for his work in this area, described how people sort money into invisible mental "buckets" and apply different rules to each.

Tax refunds and bonuses often get labelled "free money" and spent on indulgences, when the same person would never dream of spending a regular pay cheque so frivolously. Investors frequently divide their capital into "money I can afford to lose" and "serious money," then make reckless bets with the first pile. All money has the same value, and any dividing line between "play money" and "real money" is a mental illusion.

In New Zealand, one of the most significant examples of mental accounting involves KiwiSaver. Because the money is locked away until age 65 (with limited exceptions), many members treat their KiwiSaver Scheme balance as "not really my money." The result is apathy: they never review their fund choice, ignore fees, and fail to give their KiwiSaver investment the same attention they would give a bank account holding an equivalent sum. Yet for many New Zealanders, their KiwiSaver Scheme balance will be among the largest financial assets they ever hold.

Mental accounting also explains why people might carry high-interest credit card debt while maintaining a savings account paying far less. Logically, the savings should clear the debt. But the brain treats the "emergency fund" bucket as untouchable, even while the debt bucket quietly grows.

What helps

• Treat all money as fungible. Before spending or investing, ask: if this money came from a different source, would I make the same decision?
• Consolidate your financial picture. Looking at all assets and liabilities together, rather than in isolated buckets, leads to better decisions. A comprehensive financial plan forces you to consider all resources against all goals.
• Give your KiwiSaver Scheme investment the same scrutiny you would give any other investment of equivalent size. Review your fund type, fees, and provider at least once a year.

8. Trusting memories over facts: the story your brain rewrites

Every time you recall an event, the act of remembering subtly alters the memory. If you have ever played the telephone game, you know how quickly a message degrades as it passes from person to person. Each retelling introduces small distortions. Your memory works in much the same way.

What you believe happened is shaped by what you expected to happen, what you have been told since, what you wish had happened, and the emotional state you were in at the time. Research suggests about half of people can be induced to "remember" events which never occurred at all.

When it comes to financial decisions, unreliable memory is a real hazard. You might remember a past investment as more successful than it was, reinforcing overconfidence. Or you might recall a loss as more devastating than it was, reinforcing excessive caution. Either way, gut instinct shaped by faulty recall is a poor substitute for written records and verifiable data.

What helps

• When facing a financial decision, pull up the actual numbers rather than relying on your recollection of how an investment performed.
• Keep records. A simple spreadsheet or journal of major financial decisions, including your reasoning at the time, protects you from the gradual drift of memory.
• Be sceptical of narratives, including your own. The past is not as clear-cut as it feels.

The real cost of being human

These eight biases are not character flaws. They are features of the brain you inherited, shaped by pressures having nothing to do with compound interest or portfolio construction.

The Dalbar data tells the long-term story clearly. Over the 20 years to December 2024, the average American equity investor earned about 9.2 per cent per year, while the index returned 10.4 per cent. Compounded over two decades, the market portfolio was worth roughly 22 per cent more than what the average investor achieved. The FMA's research on KiwiSaver Scheme switching tells a parallel New Zealand story: members who acted on instinct during volatility locked in losses they may never fully recover.

Every percentage point lost to behavioural mistakes is money not working for your future self. The encouraging news is these biases can be managed. Slowing down, seeking diverse perspectives, maintaining a written plan, and working with an objective professional all help. If you would like to talk through how any of this might apply to your own finances, get in touch.