Even with useful tools and techniques, cognitive errors in human nature can impact financial and economic decisions. There are many different forms of bias and psychological traps that can affect decision making. These inefficient behaviors in financial settings can lead to decisions being less than optimal and sometimes quite harmful. The best system and structures are still affected by the human element in financial decision making.
While there are many different biases, the three that impact financial decisions the most are overconfidence, over-optimism, and confirmation bias (Ross, Westerfield, and Jordan 2015, 741). When a person believes they can forecast the future they are prone to make mistakes due to an overconfidence bias. This can people to overestimate their ability to pick stocks or make other financial decisions, leading to financial losses. People exhibiting over-optimism can analyze investments with a focus towards on the best-case scenario. This can lead to investments with wide ranging net present values (NPV) to be undertaken even though the most likely case may be negative, unlike the best-case scenario. Confirmation bias can also play a part in decision making when people focus on information that supports their opinion instead of viewing the information from an objective standpoint. This can lead to people ignoring information that presents risks to their investments that may lead to financial losses. These cognitive biases are pervasive in the financial world, as well as daily life, can lead to inconsistent and inefficient decision making.
Framing effects and heuristics are also important cognitive errors that impact financial decisions. Heuristics are rules of thumb that can be used to make decisions quickly. There are different types like the affect heuristic which is focused on gut instinct and the representative heuristic where small samples lead people to overgeneralize results. These can lead to situations where people trust their instinct instead of financial analysis or believing that because it has worked before something will work again, potentially leading to negative NPV investments. Framing effects can lead people to make poor decisions even if they may not otherwise due to simply how the information is presented. Since people are typically against wanting to absorb losses, framing options in a way that focuses on the positive aspects can lead them to different decisions (Ross, Westerfield, and Jordan 2015, 743). This can be both positive and negative, so is an important concept when receiving investment proposals especially.
While the market in and of itself is generally efficient, the introduction of the human element and its cognitive biases can lead to inefficient scenarios (Ross, Westerfield, and Jordan 2015, 760). It is important to understand cognitive errors when making not only financial investments, but also other life choices. These human psychological obstacles are important to understand to ensure decisions across all aspects of life are optimized for efficiency.
Author: Logan Callen
Ross, Stephen A., Randolph W. Westerfield, and Bradford D. Jordan. 2015. Fundamentals of Corporate Finance: Standard Edition. 11th ed. New York: McGraw Hill/Irwin.