In making financial decisions, people often weigh out the likelihood or unlikelihood of an event. For example, which may be a prevalent one at hand, what is the probability of a recession? Or in contrast what is the probability that the market will recover over next couple of months? In weighing the likelihood of said events, people tend to put disproportionate weight either in favor or against it due to biases they possess. Biases result from heuristics, which are decisions rules that utilize a subset of the information set, or in other words, shortcuts we use in decision making.
The following are a few common Biases:
Confirmation Bias
One tends to search out evidence in support with prior beliefs while ignore opposing evidence.
Hindsight Bias
This is the “they knew it all along” bias. After an event has occurred people believe it is more predictable than it actually is.
Overconfidence Bias
People tend to overestimate their knowledge and abilities. Most people are overconfident most of the time. There are three main forms of overconfidence which include: better than average effect, illusion of control, and excessive optimism.
Herd Behavior Bias
The tendency for people to “follow the crowd” even when it is not rational. The belief that because a lot of people make that decision it must be more likely to be right.
Self-attribution Bias
Tendency for people to assign successes or good outcomes to their own abilities and blame others for bad outcomes or failures.
Recency Bias
The tendency to believe that an event is more likely to occur if a similar one recently happened. What comes to mind easily does not necessarily mean that it is more probable.
Now think about the current market conditions we are in today. Many of you may be experiencing emotions such as fear and worry. It is understandable to be feeling this way, but it is important to recognize what may be escalating these feelings. Each of these biases lead us to certain perceptions or behaviors. Most of the time actions resulting from biases are done so unconsciously making them difficult to change. The first step to eliminating harmful biases is awareness, also the first step to avoiding harmful heuristics.
In future articles I will highlight specific heuristics and biases, giving relevant examples and tips on how to deal with them.