How cognitive bias affects investments
Thinking is hard work. Your brain uses more energy than any other organ, hogging up to 20 percent of the total energy required by your body. Just like your computer adjusts energy use in order to run more efficiently, your brain relies on shortcuts to make decisions easier.
These shortcuts or rules of thumb allow your brain to make snap judgments about potentially stupefying topics. Skimping on complex decisions such as those involved with investing saves some computing power for important tasks like dodging traffic and getting to work on time.
"The brain essentially follows heuristics or rules of thumb that we have learned through our life, and from those it creates biases, rules of thumb, that are shortcuts," says Michael Falk, CFA, partner at Focus Consulting Group, and a partner and chief strategist at Mauka Capital.
"Our brain is wired to do certain things that are beneficial to our humanity, not necessarily to our decision processes," he says.
On an evolutionary basis, cognitive biases are great. But they can cost you money and lead to poor investing decisions if you're not paying attention.