None of us are perfect – that’s what makes us all human! We all make mistakes (big or small) every day. Sometimes our mistakes are minor with few consequences, and other times our mistakes are major, perhaps we make a mistake which impacts our health, those close to us, or somehow costs us money?
We improve our chances of avoiding such mistakes if we’re aware of the common mistakes that our brains make. This enables us to make better, more rational decisions and helps us lead better lives, which of course relates to our personal finances too.
Here are the top six mistakes our brains make every day, and some tips for how to avoid them.
All of us have a pretty lousy grasp of the limits of our own competence. Regardless of the context – sports, finance, or even driving a car – we commonly all believe that our judgements, skills, and decisions are better than they really are. For example, science has repeatedly shown that 70-80 percent of us think we’re above average drivers – an impossibility! When it comes to any skill, exactly 50 percent of us must be in the bottom half.
This is a problem with the financial side of our lives too. It might mean that when we’re sure we have got something right, we don’t try to improve our understanding. We tend to not check our facts and often don’t try to learn more.
Here are a couple of things that might help fix this:
Imagine we’re watching a friend flipping a coin. The friend has flipped it five times already, and every single time it’s come up heads. We might be inclined to think that, surely, the next one will be tails? The chances of it being tails must be higher now?
Nope – the rational part of our brain knows there’s a 50/50 chance of being heads or tails every time. Even if our friend flipped heads the last twenty times the odds don’t change. (Assuming a ‘fair’ coin).
The Gambler’s Fallacy is the name for the glitch in our thinking which means we might try and predict some aspect of the future based on some sort of pattern. The problem occurs when we place too much weight on recent past events and muddle our thinking about how the world actually works, believing that irrelevant past events will have an effect on future outcomes (of course, in heads or tails, past events make absolutely no difference to the odds!).
When it comes to our personal finances, this thinking might have any number of bad impacts, perhaps you’ve heard someone say something like “This time it’s different” when it comes to investing, or “I don’t need car insurance, I’ve never had an accident”.
Remember: past performance doesn’t guarantee future results!
We tend to like and surround ourselves with people who think like us. As long as they believe and confirm what we already think, we’re more likely to be friends with them. While this makes sense, also it means that we subconsciously start to ignore or dismiss different opinions to our own. This can potentially lead to missed opportunities or mistakes.
This can lead to overconfidence, for instance, we might have invested in something then receive new information that indicates our investment was unwise. It’s inbuilt human nature to overconfidently stick with our original decision, perhaps dismissing the new information to justify that we were right all along.
Depending on the decision to be made, we can consider:
This is similar to #3.
The bandwagon effect, or groupthink, describes when we gain comfort in doing or believing something because many other people do (or believe) the same. The reason we go along with the crowd is our brain still has a basic subconscious need to conform so we’ll be liked and accepted by those around us. Humans are social by nature – we’ve inherited this from our ancient hunter-gatherer ancestors, who relied on the tribe or group to survive. Humans have weak “claws”, little fur, and long childhoods – so living in a group helped our ancestors survive without being overcome by harsh environments or predators. In more modern times, being part of a group helps people feel safe and protected, even when buildings and clothing have made it easier for one person to survive by themselves. Our underlying desire to fit in is so strong we might sometimes conform to a group consensus even when it goes against our own judgment – at least in public.
Fear Of Missing Out, FOMO for short, is closely related. That’s when we dive into something because if we don’t then we’ll miss out. Everyone’s doing it, so it must be good and we should do it too!
When it comes to our money, it might feel good to us if we’re investing with the crowd. At worst, this might even mean being sucked in by fad investments, get rich quick schemes, or just the latest trend – at times the hype around cryptocurrency has seemed a lot like this.
To succeed at nearly anything, it pays to think – and sometimes act – independently of the crowd. If we don’t have a mind of our own sometimes, then what’s the point in having a mind?
Loss aversion is the tendency we have toward avoiding losses rather than obtaining gains. Some research has suggested that loss aversion is psychologically twice as powerful to us as gains. The reason for this is our brains are wired that way: our cave-based ancestors had a higher chance of survival if they placed greater importance on avoiding threats – like a sabre toothed tiger – than they did on maximising opportunities – such as gathering a little more food.
The term “sunk cost” refers to any cost (not just monetary, but also time and effort) that has been paid already and cannot be recovered – it’s sunk.
For example, a 1980’s study had people spend $100 on a ticket for a holiday, then soon after the study subjects came across a better holiday somewhere else for $50, which meant they also bought a ticket for this second trip. Then, the study subjects found out the two trips overlapped and both tickets couldn’t be refunded or resold. Which holiday do you think they chose to go on, the $100 good holiday, or the $50 great one?
Over half of the people in the study went with the more expensive trip. It may not have promised to be as fun, but the loss seemed greater.
When it comes to investing, this is a common issue as we might be reluctant to sell loss-making investments in the hope of making our money back.
Being aware of loss aversion might help — forewarned is forearmed. For example, suppose we are de-cluttering our home. Using this knowledge, we can view each item as if we were non-owner (we didn’t yet own it) and apply a simple test: If we didn’t have the item, how much would we be willing to pay to buy it? Just by changing our perspective, we can gain a lot of clarity.
When it comes to sunk costs, the thing to remember is this: we can’t get sunk costs back, they’re gone. Our best bet is to try to separate the current facts we have and best prediction of the future from anything that might have happened in the past.
One trick is to shift our focus away from thinking about the success or failure of each individual project or investment, and instead think about the overall net impact. If several projects or investments fail, but the successes outweigh the failures, then the net position is still positive. When it comes to investing, this is why we diversify.
A large number of fascinating studies have proven we can’t even trust our own memories. To understand a bit about how our memory works, consider the “telephone game” (also known as Chinese whispers). In this game, one person quietly whispers a message to a person beside them in line, who then relays the message on to the next person, and so on. Each time the message is relayed, some parts might be misheard or misunderstood, others might get innocently altered, improved, or forgotten. Over time the message can become very different from the original.
An overwhelming body of evidence shows the same happens to our memories. There are countless reasons why tiny mistakes or embellishments might happen each time we recall past events, ranging from what we believe is true or wish were true, to what someone else told us about the event, or what we want that person to think. Half of us might even ‘remember’ events that never happened.
When these memory issues happen, they might have a negative impact on decisions we make in the present or future.
Especially when it comes to financial decisions, we need to look at and assess the facts. We should never base a factual decision on gut instinct or our memories without logically working through the data first.
Whether we like it or not, we can all be irrational. Here’s a recap of the top six ways our brains can make us lose:
2. Gamblers’ fallacy
3. Confirmation bias
4. Bandwagon effect, groupthink, and FOMO
5. Loss aversion and sunk costs
6. Placing too much emphasis on memories vs facts
If you’d like to discuss anything above with a financial professional, or discuss something else, it would be our pleasure to assist. Just drop us a line.