If you’ve been reading The College Investor for any length of time, I hope you’ve come to the conclusion that smart money management isn’t rocket science. Even the jargon-laden field of investing isn’t so difficult once you understand the basics.
However, even people who have taken the time to research and understand personal finance end up making big financial mistakes. Why is that? Part of the answer is that it’s hard to do things that we know we should do. The other part of the answer is that sometimes the “right path” turns out to be a dead end. Our cognitive biases may prevent us from making wise financial decisions even when we’re trying our best.
Below we explain five different ways that cognitive bias could hurt your pocketbook.
Survivorship Bias and Investing
Survivorship bias is the idea that people often focus on people who “survive” some process while neglecting to think about those who didn’t survive. This type of bias can be particularly influential when making investing decisions.
One of my favorite subreddits is called WallStreetBets. The people who post on this forum are taking some of the riskiest bets in investments. When I first started following the forum, shorting oil futures was the hot investment. These days, the forum focuses mainly on options trading.
One reason I love this forum is that most users are faithful to report their losses as well as their profits. That being said, posts proclaiming a $10K, $50K, or even $100K gain are a lot more interesting than a post declaring a $350 loss. When studying this forum, it could be pretty easy to assume that most investors make a ton of money with every trade. In fact, that’s not true. It’s just that those are the investments that get reported.
Instead of assuming that investors are always giving sound advice, it pays to try to figure out how many have failed along the way. Additionally, if you’re interested in active investing, and you don’t want to get your shirt taken, I strongly recommend looking into the Kelly Criterion which can help you determine the size of bet you should take (relative to the size of the portfolio).
The Skin-in-the-Game Effect and Investing Advice
Survivorship bias refers to a personal cognitive bias that can lead to suboptimal outcomes in investing. However, another bias can lead to you accepting some pretty bad advice (particularly if you don’t know who is giving the advice). The skin-in-the-game effect refers to the idea that someone who isn’t exposed to the consequences of certain advice may give bad advice.
If you’re posing questions on online forums (particularly about investments), you’re bound to get some pretty bad advice. If you ask whether you should put your $50,000 into Ethereum, someone is likely to respond, “Why the hell not?” That person has no skin in the game. It doesn’t matter to them if you lose all $50,000, and they don’t care about you personally.
On the flip side, if you're talking to someone about a random alt-coin, there could skin-in-the-game that you don't realize. They could be encouraging you to invest in something simply so they profit. I see this with some online social media personalities who are "pumping and dumping" alt coins and other speculative investments.
I think it’s great to seek advice online, but be careful before taking action. The people giving it aren’t going to bear the consequences of your actions, but you are.
Interestingly, the skin-in-the-game effect can lead to overly optimistic advice in the world of more traditional financial planning. For example, many financial advisors (as well as financial independence bloggers) advise clients to rely on a 4% withdrawal rule. That means investors can live on 4% of their base portfolio, adjusting for inflation.
However, these advisors have never personally lived on an investment portfolio and may not truly have accounted for possible massive or long-lived stock market recessions. The math of the 4% rule may be perfectly sound, but living the 4% rule is assuredly different than advising others to live by it.
Sampling Bias and Income Advice
One of the most difficult biases to overcome in the digital age is “selection” or sampling bias. When it comes to crowdsourcing ideas, you need to be very careful to take the ideas with a grain of salt. You need to ask two important questions: who is answering my question and who isn’t?
When it comes to personal finance, I see sampling bias most significantly when I see questions related to income. In particular, when I see people pose scenarios about how to raise their income, I’m shocked to see some of the advice.
In several Facebook groups that I’m a part of, the advice on raising income boils down to asking for a raise, getting a new degree, or getting a second job. This isn’t necessarily bad advice, but it's advice from average people with average jobs. Nobody who is crushing the income side of the equation is chiming in. Salespeople who bring in six figures aren’t recommending their favorite books, and entrepreneurs aren’t explaining how they launched their first product.
The advice you receive is generally a function of whom you ask. When it comes to asking for advice about income, I recommend asking people who are doing amazing work to give you their advice. Otherwise, average advice will yield average results.
I love this quote by Jim Rohn:
You are the average of the five people you spend the most time with.
So, ask yourself, who are the five people you're surrounding yourself with that are impacting your financial life?
Anchoring and Insurance Sales
One cognitive bias that I’ve personally fallen for is the concept of anchoring. Anchoring is focusing on a single piece of information when making a decision. Anchoring can be a helpful heuristic; for example, I anchor my portfolio performance expectation with the S&P 500. When the S&P 500 is down 25%, I’m not so worried if my portfolio is down 28%.
However, anchoring can lead to some pretty nasty financial outcomes particularly related to buying insurance-type products such as whole life insurance or annuities. Personally, I think that whole life insurance and annuities are derided too heavily. I can think of scenarios where these financial products would play a role - especially annuities (less so whole life - especially with the new estate tax limits).
Less-than-ethical insurance salespeople may anchor buyers' attention on a single product attribute (for example, internal rates of return or guarantees) without explaining the assumptions. For example, I purchased a whole life insurance product that assumed a 7% internal rate of return which is nearly impossible for a bond-heavy portfolio to hit these days. I purchased it because I was anchored in the 7% internal rate of return, not because whole life insurance meets my particular financial needs.
Before becoming enamored with particular features of a product, you need to be sure that the product itself is a good fit for your needs.
This also comes close to the category of financial whataboutism that we talked about before. This is where people make comparisons such as "what about this" to try and anchor the discussion around something that really doesn't matter.
It can really be a costly bias.
Confirmation Bias and Financial Advice
The last cognitive bias you (and your wallet) should beware of is confirmation bias. This is one of the most deceptive forms of cognitive bias. Confirmation bias is the concept that we share ideas with people who are likely to agree with the validity of the idea.
For example, if you’re in an entrepreneurship group, and you have an idea to start a business, the other group members are likely to applaud you. Take that same idea to your grandmother, and she’s likely to wonder why you don’t like your stable job in the air-conditioned office building.
In general, we’re going to seek out the opinions of the people who agree with us. Personally, I think confirmation bias can help us get up the guts to do something a little bit risky, so it can be helpful. That said, if you’re trying to understand a financial decision from multiple angles, confirmation bias is a sticking point.
If you only seek advice from people who think like you, you’re unlikely to come to a great decision. I see this a lot in Facebook groups focused around Dave Ramsey and Mr. Money Mustache. Both of these individuals have really "die hard" rules about money and life. Some of these groups create an extreme confirmation bias effect around each other and really refuse to listen or acknowledge that alternative approaches might be beneficial.
Before making any type of big financial decision, you need to acknowledge multiple angles to any situation.
As more and more personal finance discussions happen online, it's really important to keep these cognitive biases at the forefront of your mind. It can be hard to do - our perceived reality of the world can become skewed very quickly with different opinions, advertisements, groups, and more.
But I always remember a key lesson I learned early on about money online:
People who aren't doing well will reach out and/or post on forums much more frequently to complain, vent, or to try to improve. People who are crushing it typically don't talk about it online publicly. I think the ratio is usually 10 to 1. Keep that in mind everywhere you go financially online.