Why Do People Make Irrational Money Decisions?

Ever find yourself splurging 20,000 rupees on a pair of sneakers while barely being able to pay every month’s rent? Or spending 400 bucks everyday for a cup of not-so-great coffee and later wondering why your savings account always seems empty? Don’t worry if you do. This blog is aimed exactly to answer those seemingly bewildering questions and tell you how to not find yourself in those situations again. 

The complexities of the human brain are fascinating. Even though it is capable of processing about 11 million bits of information per second- it might still make some decisions like the ones mentioned above. Most irrational financial decisions are the result of impulse, “trusting your gut”, shortcuts, and most importantly not being able to look at a financial situation with a pair of fresh eyes and critical thinking. But luckily enough, the same brain that lets us make these decisions also has the capacity to analyze them and come up with ways to avoid them. The field of study that lets us delve deep into such topics is called Behavioral Finance. It is a field of study that combines psychology and finance. It looks at how human emotions, biases, and mental shortcuts influence the financial decisions people make- often leading them away from pure logic. Carefully reading about the five crucial biases that may severely affect your decision making can definitely help you dodge the. Therefore, they are as follows:

1. Overconfidence Bias: Overconfidence bias, also known as self-attribution, refers to a tendency to make choices based on overconfidence in one's own knowledge or skill. It’s difficult to be aware of our own limitations, and people want to think that they are good at what they are doing, often to the detriment of the outcome. Overconfidence may also result in being less willing to accept new information or listen to conflicting opinions.

2. Bandwagon-Herd Mentality: Humans are by nature tribal; we tend to find security in the crowd. We think if everyone else is doing it, there must be a good reason why I should too. Bandwagon-herd mentality states that people tend to mimic the financial behaviors of the majority of the herd. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-offs. It may also be the trigger for huge trends which fizzle out in the blink of an eye but empty out your pockets as they go.

3. Confirmation Bias: Confirmation bias kicks in when investors have a bias toward accepting information that confirms their already-held belief in an investment. The more emotional weight a belief carries, the more strongly confirmation bias is likely to exert its influence. Overcoming confirmation bias requires a willingness to become deeply self-aware, examining one’s own beliefs and perspectives and being able to hold them loosely as you explore information.

4. Anchoring Bias: Anchoring bias is seen when we find yourself relying too heavily on the first number or piece of information you see (the “anchor”). Your mind becomes preoccupied with that particular value, and new choices are made within the context of the previous information rather than adjusting the context. Every salesperson understands that beginning negotiations with a high starting price is likely to yield a higher final price, as the opening bid serves as the anchor or reference point. Therefore, having beforehand knowledge of this bias can help you up your bargaining and negotiation game.

Recency Bias: Recency bias is the tendency to give more weight to recent events than to long-term trends. In real life, it shows up when people make decisions based on what just happened rather than the bigger picture. For example, an investor might buy a stock just because it’s been rising for the past week, assuming it will keep going up.