The Art of Thinking Clearly in Personal Finance

Warren Buffett says “Until you can manage your emotions, don’t expect to manage your money”. Rolf Dobelli in his book, ‘The Art of Thinking Clearly’ has pointed out 99 cognitive errors (‘systematic’ deviation from logic) and behavioral traits that we use in our day-to-day thinking and decision making. Here are 6 common errors that affect our investment decisions and financial planning –

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6 Cognitive Errors

1) Sunk Cost Fallacy 

The author explains that many people sit through a bad movie because they have already paid the ticket price. By sitting through it, they waste their time and see something they  do not like just because the ticket prices are paid – the money is sunk.  But we do not gain anything by sitting through it. Similarly many of us hold on to bad investments made. There is no reason to retain the bad investments. They will lose more money over a period of time and the value of the overall portfolio will fall even more.

Read – Throwing Good Money After Bad

2) Herd Mentality 

The stock market, real estate or any other investment, mostly is driven by herd mentality at the end of the cycle. When it is a bullish market, prices are rising, everyone clambers to buy. Most of them do not understand why the prices are rising. When the markets are falling, people panic and start selling off their without much thought. This drives the prices further down. We should look at the reasons why the market is going down and check if we have any investment that have the risk of losing value further or have any dud investment. We should sell only those and hold on to the investment which might have a fall in price but are fundamentally sound for a longer period.

Must Read – If 10 Cr people say something Foolish, it is still Foolish

3) Confirmation Bias 

People seek out opinions that are similar to theirs. They filter out contrasting views and analysis. This affects rational decision making. Many of us do not like our opinions and theories being proven wrong. For example if we have decided to buy a certain investment  based on our research, we tend to search for news and analysis for buying the stock. We tend to ignore stories that go against this decision. This might lead us to make wrong investment decisions. We should intentionally seek out contradictory opinions and views to make sure our decision is correct.

I talked about this in 2011 – when Gold was at peak & investors were flocking to there new found love “Gold Funds” link. (must read comments on gold fund post – you will know how people react when there is euphoria in any asset class) That comment was not at all about timing the market but about investor behavior.

4) Scarcity Error 

Shopkeepers and Sellers often say that there are only 2 units left or put notices – ‘Only Until Stocks Last’. Sometimes sellers talk of many buyers being interested in the item that we are thinking of buying. (Online stores play this very smartly) Many times such tactics are used just to convince you to buy it. We then worry that we might not get it and end up buying it. Instead of responding blindly to scarcity, we should assess if we really need a product or service and then make the buy decision irrespective of how many people are buying it or how many units of the item are there in the shop.

Read – How to stop buying things you never use?

5) Endowment Effect 

Endowment effect is the ownership effect. This theory states that once a person owns something, he automatically ascribes more value to it. A person is ready to pay more to retain something than to buy the same thing if he does not have it. This affects financial planning. People who inherit some assets are reluctant to sell them even if those do not fit in their overall investment portfolio or are assets that might not be giving them the best returns. A person might buy  a stock at Rs. 400 expecting to sell it at Rs. 500 within a certain timeframe. If the stock reaches Rs. 490 but then stalls there in that timeframe, the endowment effect stops him from selling it at Rs. 490 as he feels he is not getting his due. There are lot of people who would like to sell there investment properties, but they are not able to do this because the price that they are getting is less than what someone quoted 2-3 years back or their purchase price. They need to understand that market decides price – why you think that the price was right 3 years back?

6) Loss Aversion 

‘The fear of losing something motivates people more than the prospect of gaining something of equal value.’ If we think that we might make a loss in some investment, we do not sell it thinking of the loss made. We hold on to it in the hope that we might be in the money in those investments some day. We sell the winners in our portfolio even though they might have potential to perform as we are happy to make a profit even if its not the maximum that can be made. This is incorrect. We should sell off bad investments and hold the good ones. (don’t try to link this with Asset Allocation)

We should plan our finances rationally. Investment decisions should be made on the basis of solid research, expert advice, portfolio fit and risk tolerance and risk capability levels. We should avoid getting influenced by such biases. Feel free to share your views in comment section – if you were impacted by such bias in past & later you realized, it was a mistake.