Bruce Schneier, an author who writes about how we perceive danger, gave a great talk at TED recently, outlining five cognitive biases people fall victim to when making decisions about risk.
None of the five were intended to relate to investing, but all of them can teach investors something about the rampant biases we make with our money.
1. We tend to exaggerate spectacular and rare risks and downplay common risks.
Schneier used the example of flying vs. driving. Driving is statistically more dangerous than flying, yet flying freaks many of us out.
In investing: Most recent polls in the U.S. show investors' biggest fears centre around inflation and national debt. These might be legitimate risks, but they pale in comparison to a common risk that utterly derails so many people's finances: We don't save enough.
Someone who invests their meagre and inadequate savings in gold will still have a rough retirement even if inflation takes off.
2. The unknown is perceived to be riskier than the familiar.
Schneier's example: "People fear kidnapping by strangers when the data supports kidnapping by relatives being much more common."
In investing: The Flash Crash last May caused untold anxiety. A year later, we're still talking about it posing a serious risk to markets.
In reality, though, it was a non-event. The whole thing was over in a few minutes. Most didn't even hear about it until it was over and losses were reversed. What made it scary is that it had never happened before.
Meanwhile, the risks posed by the herd mentality of buying high and selling low can be absolutely devastating to long-term wealth — yet it's culturally acceptable because it's so familiar and prevalent.
Anyone who sold stocks in March 2009 and is just now getting back into the market has bludgeoned their portfolio in an irreparable way — a scar the Flash Crash left on virtually no one.
3. Personified risks are perceived to be riskier than anonymous risks.
Schneier's (untimely) example: Bin Laden is perceived to be scarier because he has a name. (Note: His talk is a few weeks old.) Same with swine flu; it seemed riskier than it was because it had a name.
In investing: The media are good at blowing risks out of proportion by tying them to personal stories.
When markets were sinking last summer, both The New York Times and The Wall Street Journal ran articles with stories of individual investors cashing out and giving up on stocks. They were full of anecdotes like, "Greg Jones has had it with volatility and is done with stocks."
Well, good for Greg Jones. What about the millions of other people? If you looked at the data, there was no evidence individual investors were pulling out of the market in a meaningful way.
4. We underestimate risks in situations we do control, and overestimate risks in situations we don't control.
Here's Schneier: "Once you take up skydiving or smoking, you downplay the risks. If a risk is thrust upon you — terrorism is a good example — you overestimate the risk."
In investing: How many out there are drowning in credit card debt and struggling to pay the mortgage, yet losing sleep over the latest budget or inflation rising? Too many.
5. We estimate the probability of something by how easy it is to bring examples to mind.
Schneier: "Newspapers repeat rare risks again and again. When something is in the news, it is, by definition, something that almost never happens. Things that are so common they stop becoming newsworthy — like car accidents — are what you need to worry about."
In investing: There's a constant parade of commentators warning about runaway inflation in the near future, yet few ever discuss how many investors guarantee themselves poor investment results by overpaying investment advisors and actively managed funds for products that often amount to index tracking funds.
The latter just isn't newsworthy because we've come to expect that all money managers deserve seven-figure paycheques. For many, overpaying investment advisors over the course of a lifetime poses a greater risk to long–term returns than a temporary surge of inflation.
This article, written by Morgan Housel, was originally published on Fool.com. Bruce Jackson has updated it.