We like to believe that we are rational and make good decisions based on facts not emotions. Unfortunately, the truth is that we frequently make bad decisions that are not in our own best interests. You will recognize this if you've ever spent time searching for a nearby parking spot when it would have been quicker to walk from an available spot further away. Research in the fields of psychology and behavioral economics suggest that we are, as Dan Ariely puts it, "predictably irrational". That is, we constantly make the same mistakes based on a variety of predictable cognitive biases. The good news is that we can mitigate their impact using the following techniques.
Overconfidence - Our brains are programmed to make us think we are better than we are. For example, when asked to rank themselves based on athletic ability, 94 percent of men rank themselves in the top half; a statistical impossibility. To compensate, test strategies under a wider range of scenarios and add 20-25% downside to the most pessimistic one.
Risk Aversion - We dislike losses more than we like gains. For example, what would you do if given the choice between a sure gain of $100 and a 50 percent chance of $200? In this case, most people are risk adverse and would take the $100. What would you do if given the choice between a sure loss of $100 or a 50 percent chance of losing $200? In this case, most people are risk seeking and would take the 50 percent chance of losing $200 in the hope of minimizing their loss. To overcome our tendency to overemphasize losses, we should conduct risk analysis on all options - including the status quo - using consistent criteria.
Mental Accounting - We are inclined to treat money differently depending on where it comes from, where it is kept, and how it is spent. For example, having won a large amount of money gambling, would you quit while you were ahead or continue playing? Many people would gamble their winnings away rationalizing that they were no worse off than when they arrived. To avoid this, judge all investments based on consistent criteria and be especially skeptical of any investment labeled as "strategic".
Sunk Cost - We frequently throw good money after bad by rationalizing additional spending based on the faulty logic that "we've come this far." This is often seen in large projects where loss aversion leads people to spend an additional $10M to complete an uneconomic project totaling $110M rather than writing off $100M. To avoid this, ignore what has already been spent and evaluate incremental spending on it's own merits.
Anchoring - When presented with a number, we automatically gauge subsequent numbers against it, even if they are unrelated. For instance, when spending $25,000 on a new car, we find it easy to spend an additional $3000 to upgrade the seats to leather. Yet, it is unlikely that we would be willing to spend a similar amount to upgrade our living room sofa to leather. Retailers use this principle to focus us on how much we are saving versus the recommended price, rather than how much we are spending. To avoid this, compare each option against a similar one or against a baseline of zero.
False Consensus - We tend to overestimate the extent to which others share our views and have selective recall of information that reinforces our viewpoint. We are quick to accept supporting evidence and reject information that does not fit our position. To address this, introduce contrarian hypothesis, don't lead the witness, and seek objective validation of your arguments.
Herding Instinct - We have an inherent desire to conform to the behaviors and opinions of others. The stock market provides numerous examples of individuals following the herd off a cliff rather than evaluating a stock based on the fundamentals of a company. To avoid this, ask yourself if you would rather be wrong with everyone else, or right alone. As Warren Buffett said, "You're right not because others agree with you, but because your facts are right."
