Are Behavioral Biases Costing You Money?

The study of behavioral economics has revealed a lot about how different biases can affect our finances—often for the worse. Take loss aversion: Because we feel a financial setback more acutely than a commensurate gain, we often cling to failed investments to avoid realizing the loss. Another potential hazard is present bias, or the tendency to prefer instant gratification over long-term reward, even if the latter gain is greater.

For the latest on hidden influences, we talked to Mark Riepe, who leads the Schwab Center for Financial Research and hosts Schwab's Financial Decoder^® podcast, and Katy Milkman, a professor at the Wharton School of the University of Pennsylvania and host of Schwab's Choiceology^® podcast.

Katy: Research has shown that we can "debias" ourselves. In other words, awareness and real-life experience can make us better both at identifying our biases and improving outcomes—though nobody's perfect, no matter how aware or experienced you may be.

That's why it can sometimes be good to avoid certain situations altogether. For instance, understanding I'm tempted by a donut doesn't make me want to eat one any less, so it may be easier simply to avoid situations where a donut is in front of me!

Mark: What makes some of these behaviors so difficult to overcome is that they're ingrained. Being aware is a great start; however, you also have to make a conscious effort to check yourself when confronted with a situation where your biases might emerge.

For example, when the market takes a downturn, we all have an instinct to get out before it falls further, but time and again that's proved to be the least productive path. One of Schwab's investing principles is to "ignore the noise," because it's easy to lose sight of your long-term goals when the news magnifies an inevitable market downturn.

If you have a hard time tuning it out, you may want to outsource your decision-making to an impartial third party who can react to the facts, not fear. Even talking through our thought processes with others can act as a check on our worst impulses.

Mark: It does, but recent studies suggest it may not be that simple. When automatic enrollment for 401(k) plans was originally introduced, the default savings rate was set so low that employees in aggregate were saving less than if they had been left to their own devices. So, now many plans are setting higher initial savings rates and increasing them every year to at least keep pace with inflation.

Katy: Defaults can help initially, but they aren't a panacea for longer-term behavior. Even if employees invest in a 401(k) at a helpful savings rate by default, they could still tap that nest egg when they leave a job, at the expense of their future selves. That's why it's important to be cognizant of all our biases—including our preference for instant gratification. If you want a sobering assessment of just how much taxes and penalties will eat into a premature 401(k) withdrawal, look no further than one of the many early-withdrawal calculators online!

Katy: Con artists use all kinds of tricks that prey on our psychology, such as our impulse to take the person we're interacting with at face value. As silly as it sounds, even small symbols of authority, like an official-sounding title, can increase our level of trust; someone simply being nice to us can do the same thing.

Scammers also use our tendency to escalate commitment against us. They might start by getting us to give them a relatively small sum of money—which makes it more likely we'll give again when they return with a bigger ask. (It's called the foot-in-the-door technique.) And the more we grow to trust an individual, the more we resist any evidence of their deceit.

Mark: Some of the problem is just ignorance about the scams that are out there. Victims may not spread the word out of shame, increasing the odds that others will be similarly scammed. Not only should you stay up to date on current scams, but you should also share your findings with those around you—especially older folks, who are common targets. Every time I hear about a new scam, I immediately tell my mother—for her benefit and so she can tell all her friends.

Katy: One useful concept is subtraction neglect, which refers to how our first instinct when we want to improve something—be it a process or a piece of work—is to add to it, rather than eliminate elements that may no longer be serving the project.

Mark: This is especially relevant to one's financial life. For instance, you can easily accumulate accounts over the years until your holdings become a chaotic mess, rather than consolidating accounts so you can more clearly assess your whole financial picture.

A study published in 2023 in The Journal of Finance looked at the decisions made by professional portfolio managers.¹ Many had a rigorous process when it came to buying, but the decision to sell was something of an afterthought. As a result, many of the stocks they sold did better than those they kept. On the level of the individual investor, this pattern suggests that instead of thinking I have an extra chunk of money, what should I buy?—you should think How can I look across all my holdings and use this opportunity to build a better portfolio?