Four cognitive errors that hold us back
How things have changed! For a long time, economists ruled the world of finance. Now it turns out that human beings are not always the rational, self-interested creatures Adam Smith and his intellectual progeny assumed us to be. No, we can be pretty irrational at times, making the same mistakes in thinking over and over again, even though we know we should know better.
Our irrationality about money has given rise to a new field in economics known as behavioral finance. In fact, the 2002 Nobel Prize in Economics was given to noted psychologist Daniel Kahneman for his work explaining how psychology drives economic decision making. Kahneman's Nobel Prize is amazing considering he never attended an economics class!
Psychologists refer to certain irrational thinking habits as cognitive errors. Four common cognitive errors, in particular, seem to get us into trouble with our money. These are:
- All-or-nothing thinking,
- Catastrophic thinking,
- Selective abstraction,
Each of these played a significant role in the 2008 economic meltdown and each has played a role in every personal financial crisis I have observed. Helping clients avoid the traps posed by these cognitive errors is a key aspect of my role as a financial advisor. But before we get into that, let me describe what is meant by all-or-nothing thinking, catastrophic thinking, selective abstraction and overgeneralization.
All-or-nothing thinking is also sometimes referred to as "black-or-white" thinking. We engage in this kind of thinking when we categorize situations, objects, people or events into extreme, mutually exclusive categories. Something is either good or bad, on or off, smart or dumb. In reality, life is rarely so simple. There are usually many shades of gray.
Catastrophic thinking is the tendency to assume the worst case scenario. If you have ever worried that your loved-one has been in a terrible car accident just because they are late for an appointment with you, then you've engaged in catastrophic thinking.
Selective abstraction refers to the practice of focusing only on one aspect of a complex situation while ignoring other factors that might lead to a different conclusion. If you want a good case study in selective abstraction, tune into the political shows on AM radio.
Overgeneralization is what we do when we assume that because something happened once, it is going to happen again and again. We overgeneralize when we infer a general rule from too little data. Overgeneralization is an extreme form of the classic problem of induction. (How do we know that we really know something? Maybe we just don't yet know enough to know better.)
Nassim Taleb illustrates this idea in his book The Black Swan. Up until the late 18th century, Europeans "knew" that all swans were white. Then, in 1790, British naturalist John Latham discovered black swans in Australia. Suddenly, the generalized notion that all swans were white was proven wrong by the existence of a single exception. Similarly, when we take a single experience and generalize it into a "rule" we fall into the trap of over generalization.
The 2008 Meltdown
Psychologist know that these types of cognitive errors can cause serious problems in people's lives. They can also cause havoc in the market. Can you see how these thinking errors played into the recent economic crisis? All-or-nothing thinking and catastrophic thinking led some pundits and policy-makers to claim that the only way to avoid a depression was through a massive stimulus package. The fact is, we could have addressed our economic problems in a number of ways. And although we definitely faced serious problems and needed to take decisive action, there was a lot of territory between where we were and a depression. Jumping to the extreme seemed very rash to me.
An unhappy experience
An unhappy experience with a gentleman (NOT a client) taught me very clearly how dangerous these cognitive errors can be. I wrote about this experience last July in a post on Fiscal Fitness. Here is a recap of the story with the cognitive errors highlighted. Note how damaging his unhealthy thought process was to him.
In 2007 I received a call from a man wanting help managing a fairly large sum of money he inherited from his mother. I was interested in gaining him as a client, but he felt uncomfortable with my planning-based approach. He simply had to get the money in the market right away (all-or-nothing thinking) and couldn't be bothered with the planning process that is central to how I manage finances. I warned him that without a plan he was likely to get caught up in the emotions of the market. He wouldn't listen (selective abstraction). The money needed to be invested immediately (all-or-nothing thinking) and he found a broker with "a good track record" (overgeneralization) who was willing to accomodate him.
I lost track of him until he called me again in February, 2009. His investments were down well over 50 percent and he didn't know what to do. He was He was rattled by the 2008 market collapse. Now he was afraid he would lose everything (overgeneralization and catastrophic thinking). I tried to reassure him and emphasized again the need to do a financial plan, but again, he wouldn't listen (selective abstraction). He felt he had to "do something"(all-or-nothing thinking.) He couldn't sleep; couldn't eat. His wife was worried about him and so was I. He was trapped by cognitive errors and was having trouble seeing a way out. I struggled with how I could help him. Eventually I lost track of him, but if he acted on his impulse to sell he would have missed out on a huge rally in stocks causing severe financial damage to himself and his family.
The advisor's role
While cognitive errors are commonplace, most can be overcome with awareness and effort. Cognitive errors are deeply ingrained thought habits and, like most habits, they can be changed. In fact, the most valuable service a good financial advisor provides his clients is to help prevent clients from falling victim to their own cognitive errors. Wrong thinking about money is dangerous. When you work with an advisor, look for one that understands the importance of healthy thinking and practices healthy thought habits.