A team of behavioral researchers at Morningstar, using survey data from a University of Chicago survey, quantified how four biases lead people to have less in savings, more debt and lower credit scores.
Based on survey responses, 1,200 participants were sorted into three buckets: financially vulnerable, financially coping or healthy.
Any of these sound familiar?
Loss-aversion bias: When an investment falls below what we paid for it, our inclination is, rather than carefully reassess whether it remains a viable investment (or not), to tell ourselves, "I'll sell when it gets back to my purchase price." What makes you believe it's going to bounce back? People afflicted with loss aversion bias were 1.33 times more likely to be in the vulnerable group than those with lower loss aversion.
Overconfidence bias: We're often convinced we're smarter than we are. Though decades of data has shown that most professional money managers won't beat the market, billions of dollars remain invested in actively managed mutual funds. It's overconfidence for most of us to believe we have better information than others. Researchers found that people who had a high level of overconfidence were 2.2 times more likely to land in the vulnerable group and 3.33 times less likely to save for retirement.
Present bias: Delayed gratification isn't easy. A dollar spent today on something that brings us pleasure is so much more enticing than stuffing that dollar into a retirement account that we won't use for decades. People who struggle the most with present bias were 1.97 times more likely to be in the vulnerable group. Low-present-bias people, though, are 7.5 times more likely to plan ahead for their future.
Base-rate neglect bias: We can get swept away by a new piece of information that compels us to make a decision that we otherwise wouldn't if we carefully considered the probability of that piece of information being correct or useful. Participants in the bucket of a high level of base-rate neglect were 1.75 times more likely to be financially vulnerable.
To overcome present bias, automate your savings. To avoid getting caught up in new information, limit your risky behavior. Carve out just just 5% of your investments for day trading and wild ideas. Two other steps: Slow down and talk to a financial planner with an eye on the long term.
