Are Your Financial Goals Out of Reach Due to Unconscious Biases? Bob Pisani Weighs In

Many individuals believe that they make decisions based on logic, however, when it comes to investing, this is not always the truth.

In 1979, Daniel Kahneman and Amos Tversky observed that human behavior did not align with the predictions of classical economics.

Their decisions were not always based on logic. Instead of buying when prices were low and selling when prices were high, they often did the opposite.

Kahneman and Tversky proposed a theory known as prospect theory, which suggested that people do not experience gains and losses in the same manner. According to classical theories, if someone were to gain $1,000, the pleasure they would feel should be equal to the pain they would experience if they lost the same amount.

Kahneman and Tversky's research revealed that the distress of a loss is more intense than the joy of a gain. This phenomenon, which is now referred to as loss aversion, has become a fundamental concept in behavioral economics.

Kahneman and Tversky later sought to measure the intensity of the emotional loss. They discovered that the dread of a loss was more than double the pleasure of a gain.

It is understandable why many individuals are reluctant to let go of investments that are not performing well. On the other hand, people are often eager to sell their successful investments in order to secure their profits.

Throughout the years, many researchers, including Kahneman, have identified a variety of cognitive biases and mental shortcuts that people use when making decisions. These are commonly referred to as heuristics.

Biases have become a widely accepted part of our comprehension of how people interact with the stock market.

Biases can be divided into two categories: cognitive biases, which are caused by flawed reasoning, and emotional biases, which are caused by emotions. An example of an emotional bias is loss aversion.

Emotional biases can be difficult to overcome due to the fact that they are rooted in the brain's deepest emotions. Consider if any of these emotional biases are familiar to you.

Those who invest their money will have the opportunity to gain a return on their investment.

Cognitive errors are distinct from emotional reactions, as they are caused by flawed logic. This is due to the fact that many individuals lack an adequate comprehension of the likelihood of certain events and how to assign numerical values to them.

It can be difficult to make logical choices due to the abundance of preconceived notions that people possess.

These are the main points to remember:

Unfortunately, financial knowledge and understanding is still lacking due to the prevalence of financial illiteracy. Many people, including investors, are unaware of who Daniel Kahneman is. Even those who are aware of him and his work, "Thinking, Fast and Slow", still make mistakes due to the difficulty of overriding the brain's natural tendency to act before thinking.

The world is beginning to acknowledge the impact that behavioral economists have had on society.

In 2002, Daniel Kahneman was awarded the Nobel Memorial Prize for Economic Sciences for his research on prospect theory. His work was recognized for its integration of psychological research into economic science, particularly in regards to human judgment and decision-making in uncertain situations.

Subsequent Nobel awards were given to those who had done work in the field of behavioral economics. Richard Thaler, a professor at the University of Chicago Booth School of Business, was awarded the Nobel Memorial Prize in Economic Sciences in 2017. Thaler's research showed that humans often acted in irrational ways, but in a predictable manner, leading to the possibility of creating a model to comprehend human behavior.

In 2013, Robert Shiller, a professor at Yale University, was awarded the Nobel Memorial Prize in Economic Sciences in conjunction with Eugene Fama and Lars Peter Hansen. This honor was bestowed upon him for his work in helping us comprehend the effect of human behavior on stock prices.