You're not rational. I'm not rational.
We're emotional. Sometimes we're annoyed. Sometimes we're angry. Sometimes we're just hangry.
We're really no different than any other animals, except we can tell stories, and our decisions are affected by our emotions and part of that includes our biases.
Understanding these biases and how they affect our lives can be a game changer.
Table of Contents
The best example of this is the idea that something generally seen as bad for you (drinking, smoking, obesity, etc.) isn't that bad because you know people who live long lives in spite of the condition. You know a person who routinely never wears a seatbelt and has never gotten hurt (yo, seatbelts save lives).
How does this cost you? 1. Wear a freaking seatbelt. 2. Do your homework, especially if all the information you have at the moment was provided by someone else.
You can be led astray and make poor financial choices because you don't have enough information and have overvalued what you do have.
How does this cost you? Have you ever met someone who has invested in actively managed mutual funds? The average expense ratio for an actively managed mutual fund is around 1.5%. Whether or not that sounds high to you depends on how much you know and many people's first experience with mutual funds was in a 401(k) – where 1.5% is not expensive. It's not cheap but it's not ridiculous.
Actor Observer Bias
How does this cost you? This hurts you most when you attribute your own bad choices to environmental or other factors beyond your control. Sometimes there are external forces at work that you can't control but often your choices are your own.
How does this cost you? The herd mentality is always dangerous because people stop making independent decisions and start looking towards others, who may not have more knowledge or expertise, for guidance. This can lead to situations where you opt to do something you otherwise wouldn't have.
This plays out most vividly whenever you talk about race and stereotypes. We tend to remember all the times a person of a particular background behaves in a way that confirms the stereotype without doing the same for counterexamples because they don't even register. We don't actively avoid that information, we don't retain it.
It's a common stereotype that Asians are good at math. Whenever you see an example of an Asian student being good at math, you remember it. I bet you can picture a few Asian people who are good at math right this moment.
But, when you see an Asian student who isn't good at math, it doesn't resonate. You don't even think about it because not everyone is good at math. Ignoring the fact that “Asian” encompasses thousands of ethnicities. Just looking at the Chinese, the population of China is almost 1.4 billion and they can't all be good at math!
How does this cost you? You lose objectivity in your decision making. You need to remember to look at the data objectively and not rely on your memory for evidence because your memory is selective and awful.
When studied, this is often linked with a behavioral model known as Willingness to Accept or Pay (WTAP). People often have a higher Willing to Accept (WTA) price than a Willing to Pay (WTP) price, where WTA is the price at which you'd sell an item versus what you'd pay for it.
How does this cost you? The relatively recent United Airlines fiasco is a prime example of this – United tried to convince people to take a voucher when they were already in their seats. Tyler Cowen goes through some game theory on how they could've played it differently and mentions the endowment effect, it's really hard to get people to take a voucher when they're already in their freaking seats.
Extremeness aversion is our tendency to avoid extremes, either too risky or too safe. Too risky of an investment and we tickle our loss aversion bias. Too safe and we have a bit of FOMO. The same applies too expensive and too cheap, which is why restaurants design their menus a certain way. 🙂
How does this cost you? Rather than analyze decisions independent of their relationship with one another or in our broader plan, we take the available information (availability heuristic) and use that to pick what is not an extreme. Nefarious actors on the other side of your decision can take advantage of this extremeness aversion and design sub-optimal choices in the middle.
False Consensus Effect
There are two theories as to why this happens. The first is that through social comparison – we compare ourselves with others and use others' beliefs almost as an anchor. The second is of projection, we project our beliefs and feelings onto others.
How does this cost you? This can lead to social faux pas, which can hurt us financially if these are in business and work situations too. Another way this can affect us is leaning on our inclination for conformity – which can be enough of a push to get us to make decisions not necessarily in our best interest.
The halo effect is when you inflate your evaluation of a person's specific traits and characteristics because of how you feel overall about that person. The people you tend to like are often viewed as smarter, funnier, more hard working, and other positive traits.
How does this cost you? If you don't know you're evaluating someone higher simply because you like them (or just the way they look), you can make decisions based on likeability rather than actual ability. This can be a mistake when it comes to selecting advisors, like a financial advisor or lawyer, and it's important you lean heavily on quantitative measures over qualitative ones.
It happens when your favorite team loses the game because your favorite team always loses big games (if that were true, why did you even watch?).
Or how you always seem to know the class material after you've taken the final (duh, you just saw the questions on the test).
How does this cost you? This is less directly harmful than some of the other biases, like optimism or survivorship, but it does impact you. It can lead you to believe you are a better predictor of events than you actually are, which can lead to decision making mistakes.
It can also lead you to feel a sense of inevitability towards events that are not inevitable and can be prevented. If you have a family history of lung cancer, you may believe it's fine to smoke because you're going to get lung cancer anyway.
She lost her mother when she was 14 but remembered little of the event. On her 44th birthday, an uncle told her that she had discovered her mother's body – which triggered a rush of vivid memories. Except her uncle mispoke, it was her aunt who had discovered the body and all those memories she had were false. (more on that!)
How does this cost you? There's not as clear a line between this effect and its impact on your money, but it's still important to understand. Misinformation happens all the time, sometimes accidentally and sometimes on purpose. Understanding that your memory is fallible (and biased) so always look for facts to back up your beliefs, no matter how strong they are. Also, understanding how a question is phrased and how it can influence your answer is insightful.
How does this cost you? This “everything will work out” type of thinking can result in a bit of complacency when action is required. If we have a tendency to under estimate negative events, we may not save as much into an emergency fund because we “won't need it.” Isn't it better to get a higher rate of return from the stock market?
If we overestimate positive results, we may plan for events that are easily delayed like raises and promotions. We jump into a new business venture or invest more aggressively than we should have. It requires us to be far more diligent in our predictions and our planning.
To see this in action, answer this question – how fast can you throw a baseball? I've had the benefit of doing this at a science center and my actual throwing speed is lower than what I would've guessed. I would've guessed somewhere in the 70s. In reality, it's in the lower 60s — never topping 65 MPH.
How does this cost you? Overconfidence never hurt anyone! 🙂
An even more pervasive phrase is that of the “new Normal.” It's when you take recent events and make them the baseline for the future, rather than using data you have for decades.
How does this cost you? If there's a tendency to give more weight to events that happened recently, then you need to work extra hard not to fall into the trap. There is a ton of data out there for nearly everything, so make sure you look at it all and not just what happened lately.
There's a reason Roulette tables show a history… it's because they know we have biases.
One of the most famous stories about survivorship bias involves a statistician during World War 2. Abraham Wald was a statistician in the Statistical Research Group and they were trying to reduce bomber losses. They had data from bombers returning from raids and were trying to use it to adjust the designs to build a better bomber. What Wald realized was that the data only showed bombers that survived, meaning the damage they sustained was not enough to bring down the aircraft. Reinforcing where those bombers were shot would not improve survivability, in fact doing the opposite would be more effective.
The data was biased because it came from surviving bombers. The ones that didn't make it back never reported where they were damaged.
How does this cost you? It's harder to pinpoint specific cases where a survivorship bias alone can cost you money but a good example is if you only study success stories then you could have a biased view of what leads to success. How you define successful can also have a similar impact.
At an extreme, if you only studied Steve Jobs, Mark Zuckerberg, Bill Gates, Michael Dell, Evan Williams, and Larry Ellison then you might believe that the path to becoming a billionaire means dropping out of college. In reality, a four year college degree can mean over $800,000 in lifetime earnings (Federal Reserve Bank of San Francisco, 2014)
How this works in real life
The place to see your biases and logical errors used against you is in a restaurant. Those menus are designed to get you to order certain items over others.
Don't believe me? Read this very short article on Wired about menu design and then pay attention the next time you visit a restaurant.
Of course – not all restaurants do this.
We recently dined at Mikael Jonsson's Hedone (Michelin Star and named one of the Top 100 Best Restaurants in the World) and their menu consists of just two choices – do you want tasting menu for £95 or the tasting menu for £135? (go for the £135!) Not everything involves games.
What bias do you recognize and combat frequently?