💰 Why Smart People Make Bad Investment Choices

Reading time: 3 mins 28 seconds

Hey there, WTL readers!

So last week, you learned that taking risks that have the potential to wipe you out is not a risk worth taking.

This week, I’m going to explain to you WHY we can be susceptible to taking such risks, and why smart people make bad investment choices.

Let me introduce you to Mr. CB—no, it’s not Chris Brown.

I’m talking about Cognitive Biases.

These are systematic errors in thinking that affect the decisions and judgments that we humans make. They are often a result of our brain's attempt to simplify information processing. In the context of personal finance, these biases can significantly impact how we manage our money and make financial decisions.

Understanding the influence of cognitive biases on your investment decisions and personal risk-taking behaviors can have several benefits. It enables you to avoid common financial pitfalls, make more informed decisions, and significantly improve your financial well-being. Furthermore, by mitigating the effect of these biases, you can manage your investments more strategically and optimize your risk-return trade-off.

Unfortunately, many individuals do not comprehend the profound impact of behavioral biases on their financial decisions.

Lack of awareness is the primary reason why.

Other reasons people struggle to recognize and mitigate cognitive biases include:

• Reason #1: Insufficient financial education

• Reason #2: Overconfidence in personal decision-making abilities

• Reason #3: Denial or disbelief in the existence of cognitive biases

• Reason #4: Difficulty in altering established decision-making patterns

However, don’t worry! I’ll help you overcome these challenges and make more informed financial decisions.

Step 1: Educate yourself about behavioral finance and cognitive biases.

Understanding behavioral finance and cognitive biases is crucial because these biases can often lead to irrational financial decisions.

Certain cognitive biases can lead individuals to take disproportionate risks in their financial decisions, potentially exposing them to significant losses.

Here are some of the most notable:

1. Overconfidence Bias: Overconfidence can lead individuals to underestimate risks and overestimate their own abilities or the quality of their information. This bias can lead to excessive risk-taking, such as placing too much money in a single investment or making speculative trades.

2. Optimism Bias: Also known as the "wishful thinking" bias, this is the tendency to overestimate the probability of positive outcomes and underestimate the probability of negative outcomes. This can lead to overly risky investments or financial decisions.

3. Illusion of Control Bias: This bias leads individuals to believe they can control or influence outcomes when, in fact, they can't. In investing, this can lead to risky behavior, such as day trading or making large bets on individual stocks.

4. Dunning-Kruger Effect: This bias occurs when individuals with low ability at a task overestimate their ability. In the realm of investing, novices may not realize their lack of understanding of complex financial instruments and might take unnecessary risks as a result.

5. Gambler's Fallacy: This is the belief that past events can influence future probabilities. For instance, after a series of losses, an investor might believe that a win is "due," leading them to take high-risk bets.

6. Herd Mentality: This bias can cause individuals to follow the crowd into risky investments, based on the belief that a large group couldn't be wrong. This can often lead to financial bubbles and subsequent crashes.

Step 2: Reflect on your past financial decisions.

Now that you’re aware, take the moment to revisit your financial decisions.

Neglecting to review past financial decisions critically is a huge mistake, because it can provide insights into your cognitive biases.

My not-so-recent loss was because of Herd Mentality.

Remember Axie Infinity? I lost 70% of my capital there. I saw not only friends but also reputable people from the personal finance space jumping on this hot trend back in early 2021. I studied it and was convinced to put money in by mid-year, but unfortunately for me, it was the start of its decline.

Though it wasn’t a huge chunk of my net worth, I still felt the loss.

I’m human after all.

Step 3: Implement strategies to mitigate these biases.

Knowing there are ways to counter these biases can help you see the light at the end of the tunnel.

You can employ several strategies to mitigate these biases. For example, setting predetermined rules for buying and selling investments can help overcome the impact of emotional biases. Also, seeking professional advice or using robo-advisors can bring objectivity into your decision-making process. By taking these steps, you are much more likely to make sound financial decisions and thus improve your overall financial health.

As for me, after the loss I had from my cute little Axies, I’ve decided to double-down on my investments in improving my God-given skillsets. I enrolled in entrepreneurial masterclasses and mentorships, which gave me the best ROI yet.

This is definitely not the last time that I’ll be talking about Cognitive Biases as they affect all areas of personal finance.

Master these biases, and you’ll be in a much better financial position than others who don’t know a thing or two about them.

Whenever you’re ready, here are two ways I can help you:

• 1-on-1 Personalized Coaching: A three-session coaching program where we’ll discuss your financial goals, build your own money management system, improve your money habits and guide you on how to invest on your own.

• Group Coaching: Four live 60-minute zoom calls that will guide the students on the step-by-step guide to improve their finances.

Learn more by scheduling a 15-minute discovery call here.