The Science Behind Why You Make Poor Financial Decisions
As much as we strive to make informed financial decisions, our brains are wired to make mistakes. Even the savviest investors among us can fall prey to cognitive biases that lead us to make poor choices. Understanding the science behind why we make such blunders can help us take steps to invest more wisely.
Why do we make poor financial decisions in the first place?
The answer lies in the way our brains process information. Our brains have two different systems for making decisions: the logical, rational part of the brain, and the fast, instinctive part. The fast part of the brain, also called the “lizard brain,” is responsible for our fight-or-flight response and works quickly to help us make snap decisions based on our emotions.
Unfortunately, this part of our brain is rarely a good foundation for financial decision-making. When making financial decisions, we need to access our rational, logical brains to weigh the pros and cons carefully. But because our brains are hardwired to prioritize the fast, emotional parts of our brains, we often make mistakes that can cost us big-time.
Case examples show just how easy it is to make poor decisions when emotions are involved.
For example, consider the so-called “sell-off” that occurred in 2008 when the market took a nose dive. Many investors panicked and sold off their assets, only to later regret that decision when the market rebounded. Another example is the all-too-common tendency to hold on to a losing stock, waiting for it to “come back” instead of cutting losses and seeking out better opportunities.
So, how can we make better financial decisions?
One way is to recognize the cognitive biases that can lead to poor decision-making. Confirmation bias, for example, is the tendency to seek out information that confirms our existing beliefs or biases. It can be hard to view a situation objectively, but seeking out information that goes against our beliefs can help us see the full picture and make better-informed choices.
Another bias to be aware of is the sunk cost fallacy. This occurs when we make decisions based on the idea that the resources we’ve already invested (time, money, or effort) should influence our future decisions. For example, losing money on a stock can feel like a sunk cost, leading us to hold on to the stock longer than we should with the hope that we can recoup our losses.
By recognizing these biases and taking steps to combat them, we can become better investors and make sound financial decisions based on logic, rather than emotion.
FAQs:
Q: Why do we make poor financial decisions?
A: Our brains are wired to prioritize emotions over rational thought, leading to mistakes.
Q: What is confirmation bias?
A: Confirmation bias is the tendency to seek out information that confirms our existing beliefs or biases.
Q: What is the sunk cost fallacy?
A: The sunk cost fallacy is making decisions based on the idea that the resources we’ve already invested should influence our future decisions.
The Science Behind Why You Make Poor Financial Decisions
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