In last week’s post about the credit card debt puzzle, I ranted and rambled about cognitive biases. These are the kinds of things that I think about on the daily and fail to realize that they are not in everyone’s vernacular. Time for a little lesson…
A cognitive bias is a systematic error in thinking that affects the way and individual makes decisions. It often causes an individual to deviate from using good judgment and/or behaving in a way that is considered rational. Several things can contribute to these biases including but not limited to memory, attention, and experience. There are a lot of different types of cognitive biases – the Wikipedia page lists over 150! This post will focus on a few, particularly those that are relevant for economics.
Gambler’s Fallacy – The tendency to think that future probabilities are altered by past events. The classic example is that of flipping a coin and thinking there’s no way that you’re going to flip another heads if you’ve just done it 3 times in a row. In reality, these probabilities are independent and the 4th flip is in no way affected by the first 3.
Planning Fallacy – The tendency to underestimate how long a task if going to take. This paper explores this in an economic framework and explains why it is optimal for people to use commitment devices (i.e. deadlines) to keep them on track with goals.
Irrational Escalation – The tendency to continue making an irrational decision based on a decision that was once rational. This is similar to the idea of sunk costs. People who accumulate large amount of credit card debt (like those in the puzzle group) may fall in to this category. The line of thinking is something like “well, I already owe $2,000 on this card that I can’t pay off, so what’s another $300?”
Ingroup/Confirmation/Projection/Bandwagon Effect – So these are not all the same, but they are very similar. Basically its the tendency to conform beliefs based on the people around you. This comes up a lot around elections and why we see such strong bias in the media.
Negativity Bias – The tendency of people to have greater recall for bad memories than good ones.
Self-serving bias – The tendency to claim more responsibility for successes than failures. AKA the classic politician move (with the exception of those as self-actualized as George Washington)
Functional fixedness – Limits a person to using an object only the way that it is typically used. Perhaps something that central bankers and policy makers should reflect on.
Curse of knowledge – The tendency of well-informed/highly educated people to fail to see things from a different perspective. Academia and business alike are rife with examples of this.
There are many other biases out there and they really come into play when it comes to personal finance. I encourage everyone to think about how these affect your everyday thinking.