Cognitive Bias & Financial Literacy
I’m Andy Temte and welcome to the Saturday Morning Muse! Start to your weekend with musings that are designed to support your journey of personal and professional continuous improvement, and to improve financial literacy around the world. Today is March 15, 2025.
Over the last few weeks, we’ve been exploring the relationship between price, value, and decision-making, and last week we made the recommendation to engage in self talk to challenge preconceived notions and biases that impact our day-to-day spending habits. We also reviewed a short list of subconscious (a.k.a., cognitive) biases that included confirmation bias, decision fatigue, the disposition effect, the messenger effect, loss-aversion, optimism bias, and the sunk cost fallacy.
As we continue our journey to build financial literacy skills, you may be wondering where all the formulas and numbers are? Well, this is a big misconception of financial literacy—that it is more about numbers than it is about behaviors. How we feel about money & investing and how we behave with the resources we have via the decisions we make are as, or more, important than our ability to work with numbers. Hence, this is where we’re going to place most of our initial emphasis.
While behavioral finance and economics are not new ideas, their mainstream adoption as integral components of practical and academic finance and economics is. Looking through the long lens of time, the 18th Century economist and philosopher, Adam Smith—the “invisible hand” guy—alluded to the impact that feelings and behaviors had on markets and asset prices. However, it wasn’t until the very late 1970s and 1980s that behavioral economics and finance began to be taken seriously in academic circles. There won’t be a quiz, but Daniel Kahneman, Amos Tversky, and Richard Thaler are household names in academia. Kahneman won the 2002 Nobel Prize in economics for his work in the field and Thaler is also a Nobel Prize winner.
When I was a finance graduate student in the Ph.D. program at the University of Iowa in the early 1990s, behavioral finance concepts were still “new” and were subject to criticism by more quantitatively-oriented academic thought leaders. The thinking was that market participants were “rational” and asset prices were a function of standard supply and demand forces and could be modeled by discounting future cash flows to the present. I can’t tell you how many academic studies I read where the assumption of “market rationality” was noted in the first few paragraphs.
I know we haven’t talked about discounting and supply and demand—essential financial and economic concepts that we’ll cover in an appropriate amount of detail in future episodes—but the point I’m trying to make is that behavioral finance and economics are fairly new and are finally being taken seriously by academicians, business leaders, and investors. To see just how mainstream, I recommend picking up Kahneman’s Thinking, Fast and Slow (2013).
So let’s get back to the cognitive biases that affect our economic and financial decision-making. Richard Thaler co-authored Nudge: Improving Decisions About Health, Wealth, and Happiness (2008) with Cass Sunstein. This quote from that book sums up the need to understand the biases that lurk inside our brains.
“People often make poor choices—and look back at them with bafflement! We do this because, as human beings, we all are susceptible to a wide array of routine biases that can lead to an equally wide array of embarrassing blunders in education, personal finance, health care, mortgages and credit cards, happiness, and even the planet itself.”
Since understanding cognitive bias is so important to financial literacy, let’s close out today’s episode with a few more that are in the “must have a basic understanding of” category.
Anchoring Bias can be thought of by the more common phrase “jumping to conclusions.” In anchoring bias—you place tremendous weight in your decision-making process on the first piece of information you receive and put less weight on subsequent information. That first piece of information is known as the anchor.
Herd Mentality is where you “follow the crowd” instead of making an independent, data-driven decision. Herd behavior is prevalent in all sorts of buying and selling situations. If an influencer (messenger) says “buy,” many people will buy whatever is being recommended without engaging in independent critical thinking.
Overconfidence Bias is related to optimism bias that we discussed last week. Overconfidence bias is where you overestimate your own ability to reach a decision and you end up ignoring or minimizing expert advice. Overconfidence doesn’t just show up in economics and finance. We routinely overestimate our knowledge, skills, and abilities in many aspects of our lives.
Choice Paralysis occurs when we go on cognitive overload when we’re faced with too many buying options. Ever stood in the cereal aisle at the grocery store and caught yourself staring blankly at the dizzying array of options. When this happens, we either don’t buy anything or we revert to what we’ve always done because that’s the path of least resistance.
The Endowment Effect occurs when we overvalue something just because we own it. I’m routinely disappointed when I sell a car or boat because I’ve convinced myself that it should be worth more because I was the owner. “I’ve taken great care of this car—I should get a lot more for it!”
Loss Aversion. I know we talked about this last week in conjunction with the concept of the disposition effect, but I want to be sure to call it out separately. Here, we feel the sting of a loss more than we feel the joy or pleasure of experiencing a gain of the same amount.
We’ll be talking about and will be referring to the tenets and impacts of cognitive bias as we continue to explore the concept of financial literacy. For now, it’s important to know that we are all biased. It’s a feature of the human condition that can also be a bug that negatively impacts our ability to make sound, rational decisions. We routinely make assumptions and take mental shortcuts as we make our way through each day. To imagine that we are not biased is itself cognitive bias (a bias known as Naïve Cynicism)!
Until next time. Grace. Dignity. Compassion.
