The human brain is a marvel. Efficient, multi-functional, long and short range capable, and trainable – with billions of neurons at its disposal. But it’s not perfect. It turns out that some of the techniques that the brain uses to learn, decide and act efficiently can lead us astray.
Here’s what’s going on. To operate efficiently and make thousands of daily micro decisions, the brain creates shortcuts, called “heuristics.” Physiologically speaking, the brain is a little lazy: deep thinking takes up a lot of energy. Heuristics help your brain conserve energy by allowing it to not have to spend much time on the easy stuff. They are the brain’s coping mechanism for the fact that there’s simply too much information out in the world to understand everything in detail, allowing the brain to not have to follow a thorough and logical process for the thousands of decisions – big and small – that we must make every day.
But because our brains rely on heuristics just to get through the day, they can sometimes backfire. We love “rules of thumb,” even if they’re wrong. Not only that, but once these rules of thumb are set in our brain, we don’t really reconsider them. As Mark Twain is credited with saying, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
And it’s not just the mental shortcuts themselves that cause problems, but the cognitive biases that they create, which can negatively impact our judgments and decisions. Interestingly, we’re often unaware of some of these deeply rooted biases and shortcuts since it’s our brain itself that creates them.As a result, we must make an extra special effort to take notice and manage them. Sounds easy enough, except for the fact that some studies suggest the existence of over 100 biases at work in the human brain. Some of the most prevalent include:
Endowment Effect – the tendency for us to ascribe more value to products or ventures that we helped build. For example, we’re shopping for ceramic coffee mugs and won’t pay more than $5.But if we were into pottery and had made the ceramic coffee mug, we wouldn’t think twice about believing it was worth at least $10.
Bandwagon Effect – the tendency to conform. Humans have a strong need to fit in. Our decisions are very much affected by what others around us are doing. This happens a lot in the stock market.
Status Quo Bias – the tendency to keep things “as-is” because change is difficult and its more work to do something new than keep doing what we’re already doing. This bias manifests itself in the quote: “If it ain’t broke, don’t fix it.”
Availability Bias – the belief that information that is readily available is better or more accurate. This is why marketers want their clients to be on the first page of Google search results.
Anchoring – the tendency to focus on a specific data point or specific piece of information (to the exclusion of other information). The most common example of this is when we anchor the value of our house on what we paid for it, without giving sufficient importance to what the local housing market says our house is worth.
The Halo Effect – when we allow an impression formed from a single trait or characteristic to influence multiple judgments or ratings of unrelated factors. Put another way, this is believing that because your dentist is so amazing at being a dentist that you should also believe her financial planning advice, or that just because your financial planner is so good that you should take his advice on hang gliding.
How our brains create and use shortcuts and biases is an area of rapidly expanding research with far reaching implications. We’ll have many more posts on this topic in the future, focusing on how we can manage our mental heuristics and biases so that we don’t undermine our financial futures.