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By: Sam Instone

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December 13th, 2018

5 common mental errors that affect good decision making

Financial Planning | Pensions | Investment

I like to think of myself as a rational person…

But I’m not.

None of us are, in fact.

As humans, we are irrational and make mental errors.

Here are 5 of the most important ones to know.

In recent years…

Psychologists and behavioural researchers…

Have uncovered a wide range of mental errors…

That derail our thinking…

And often lead to poor decision making.

There are dozens of them…

(Some of which are quite technical)…

So I’m going to talk about the 5 most common…

That frequently show up in our lives.

1. Survivorship bias

You know how I often advise against listening to the media

And instead blocking out the noise?

That’s because headlines and stories…

Are filled with survivorship bias these days.

Anywhere you see articles with headlines about things like…

Investors making millions from Bitcoin

Active fund managers who made their clients super wealthy…

People who’ve won the lottery…

You are seeing survivorship bias in action.

The term refers to our tendency to focus on the winners…

And to try to learn from them…

While completely forgetting about those who didn’t win…

Or employed the same strategy unsuccessfully.

The Survivorship Bias

2. Loss aversion

You may remember the blog post I did on this.

It refers to our tendency to strongly prefer avoiding losses over acquiring gains.

Research shows that if someone gives you $10…

You’ll experience a small boost in satisfaction.

But if you lose $10…

You’ll feel the loss more deeply than you did the gain.

Our tendency to avoid losses…

Causes us to make silly decisions…

And change our behaviour.

Investors who are loss averse may be risk averse as well…

Opting for ‘safer’ investments…

Instead of those that could offer potentially higher gains.

Pain From Loss

3. The availability heuristic

This common mistake happens…

When our brains assume that the examples which first come to mind…

Are also the most important.

For example…

Research by Steven Pinker at Harvard University has shown…

There are more people living in peace right now than ever before.

People are shocked to hear this.

And some refuse to believe them.

If the world is so peaceful…

Why are we always hearing about wars…

Violent crimes…

And destruction?

Enter the availability heuristic.

See, we also happen to be living in the most reported time in history.

Information on any disaster or crime is more widely available.

(And we all know bad news sells more than good).

Because of this…

Our brains assume they happen with greater frequency.

We overvalue and overestimate the impact of things we can remember…

And undervalue and underestimate the prevalence of the events we hear nothing about.

It’s why I told you before that new funds are best avoided.

All the fanfare and news headlines…

Could lead us into the territory of the availability heuristic…

Ultimately causing us to buy in…

Without proper judgment.

The Availability Heuristic

4. Anchoring

Living in Dubai, there are jewellery stores around every corner.

In the windows…

Glistening pieces sparkle…

With price tags that seem unattainable.

But once you step inside, there are more affordable ones.

Like a watch for $500.

While, under normal circumstances, this price alone may seem a little steep…

Compared to those in the window…

They seem more reasonable.

This is how business owners move the average up.

Many of the premium products that businesses sell…

Are never expected to sell many units themselves…

But they anchor your mindset…

Making the mid-range products appear much cheaper…

Than they would on their own.

It’s why I often talk about value rather than price.

A more expensive product may seem like you’ll be getting more value…

But how much are these costs affecting your returns?

And are the extra charges delivering real value?

5. Confirmation bias

This is our tendency to search for…

(And favour)…

Information that confirms our beliefs…

While ignoring information that contradicts them.

For example:

Someone believes that buying into a particular fund is a good idea.

So they research and read stories about how great the product is…

Which confirms and supports their current beliefs...

Without considering there are ‘two sides to every story’.

The more you believe you know something…

The more you filter and ignore all information to the contrary.

It’s not natural for us to formulate a hypothesis…

And then test various ways to prove it wrong.

It’s far more likely that we’ll form one ‘decision’…

Assume it’s true…

And look for information to support it.

People don’t want new information…

They want validation.

The Confirmation Bias

Two heads are better than one

Getting a second opinion on anything is important.

But more than that, is an unbiased opinion.

Find a financial planner who will tell you the truth…

Look after your best interests…

And ensure that the decisions you make…

Fully support your future goals

And not their own.

While validation may feel great now…

Having a dream retirement

The house you’ve always wanted…

Or the means to afford the best education for your children…

Feels even better.

Chat to us if you’re looking for sound financial planning.

Book a 15-minute discovery call

About Sam Instone

Sam Instone, Director at AES International, is passionate about positive change and ensuring international investors get better results.

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