How this cognitive bias can make you bad at investing, working & other money choices

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How this cognitive bias can make you bad at investing, working & other money choices

Money Science examines the latest personal finance research.

Let's say you're getting a $1,000 bonus. Congratulations. Great news, right?

Now, let's say, just before you get your bonus, the company announces it's had some money troubles and needs to cut your bonus in half. Now the news doesn't seem so great. You would have been psyched to receive a $500 bonus, but knowing you could have gotten $1,000, it feels like a loss.

"We feel more upset when we feel the loss of a gain than how much happier we would have been with the gain in the first place," said Prateek Agarwal, creator of the Intelligent Economist blog.

This is because of a cognitive bias, or rather a group of biases, called reference dependence. Reference dependent biases cause people to respond to gains and losses more than absolute values, like when a 60-degree room feels like a sauna after coming in from a winter day.

Some types of these biases can keep people from making rational choices when it comes to personal finance.

Investing & reference dependence

One of the most important ways reference dependence can affect personal finance is in investing. One way is through a specific bias called loss aversion.

While reference dependence is the idea that people are more sensitive to gains and losses, loss aversion says we are more sensitive to losses in particular. Loss aversion is often cited as a reason for why people don't invest enough in stocks, said Michaela Pagel, a professor of business and finance at Columbia Business School.

"This fear of losing money prevents people from investing in the first place," Pagel said.

In other words, people overvalue the risk of investing in the stock market and undervalue the reward. Loss aversion can affect how investors manage portfolios as well, by causing them to take on more risk to avoid losses than to realize gains.

Imagine two investors: Investor A has a stock that has declined in value since he bought it, and Investor B has a stock that's gone up since she bought it. Each stock is just as likely to go up or down, but loss aversion says Investor A
will hold on to his loser stock, while Investor B will sell her winner.

"Because people really hate making losses, if they've already lost money on the stock, they're prepared to take a gamble that if they just hold it, maybe it's going to come back," said Mark Dean, a professor of economics at Columbia University.

If you're looking to get started with investing, we have a roundup of the best investing apps here.

Mugs

A famous experiment illustrating reference dependence involved researchers giving mugs to half of a college economics class. The students with the mugs were asked how much they would sell the mugs for and those without were asked how much they would buy the mugs for. The sellers valued the mugs at about twice the price of the buyers.

"To give up the mug required a lot more money than they were willing to pay to get the mug," Pagel said.

This reluctance to give up what we have might explain why negotiating can be tricky. (We have a guide on how to negotiate a job here.)

Taxi drivers

Several economists have studied how reference dependence affects taxi drivers. Many drivers have an idea of how much money they want to make in a day. Once they hit that reference point, they often stop working.

Because of this, drivers might be squandering an opportunity to make more money. Let's say a driver has a great day and hits his revenue target in two hours. Studies find many drivers quit for the day in this situation, even though it would be more advantageous to take advantage of the high volume and keep working, Pagel said. In contrast, many drivers work longer hours during slow days, even though they earn less money per hour.

Insurance

Insurance wouldn't exist without loss aversion. But Pagel said loss aversion goes too far when people choose health insurance plans. People tend to overrate the risk that they'll get sick or have an accident, choosing high-premium, low-deductible health plans. This means they pay much more for their health insurance up-front.

"People do not seem to choose deductibles in a way that makes sense in terms of the real likelihood of accidents," Pagel said. (Want to make a high-deductible plan work for you? Read our guide.)

The same might be said of people who buy phone insurance plans, which are often priced too high compared to the risk of losing one's phone, she said.

Overcoming reference dependence

One way to beat this bias is to take a long-term view, Pagel said. Avoid agonizing over every up and down of your retirement portfolio. The long-term trend of stock market performance leans positive.

The same advice can help entrepreneurs like taxi drivers, as well as people buying health insurance — a high-deductible health plan might be more worthwhile if you pair it with a health savings account. But it can be hard to overcome your brain's natural tendencies.

"The easy solution is to say that we need to think rationally," Agarwal said. "Unfortunately, we are not as rational as we may seem, so it's a difficult problem to overcome."

Want more Money Science stories? Learn how personal finance classes can help you repay your student loans.

Image: Phillip Blackowl