Avoiding cognitive bias in financial decision making should be part of financial literacy education, especially for those who have been subject to financial exclusion, or are engaging in a first income-generating business. The concepts are simple, but the consequences can be profound if not understood and addressed.
A cognitive bias can be thought of as a shortcut in the way we process information and make decisions. Understanding the way we are likely to respond, we can step back, consider carefully, and then make more well-considered financial decisions. An example of a common human cognitive bias is confirmation bias.
If we already have established beliefs, when we encounter new information, we are more likely to believe information that confirms what we already believe, and discount information that goes against our beliefs. We also have a tendency to give too much credence to the first bit of information we receive. The false consensus effect is a tendency to overestimate how much other people agree with us; optimism bias is the belief that misfortune will likely happen to someone else.
Just these simple cognitive biases can cause significant difficulty in financial decision making. If a person wants to start a small business, and has access to microfinance to fund the startup, most do some market studies before settling on a business and a place. By understanding our tendency toward cognitive bias, we can avoid common problems and study markets with a clear eye. We are more likely to be careful, and not believe what we want to believe.
Understanding cognitive bias can be demonstrated simply as part of financial literacy education. Consider a three dimensional geometric shape, such as a pyramid or a diamond shape. When we view a three-D object, we can only see some sides of it. There are always parts that are hidden from our view, but that we infer, such as the shape of the bottom. To avoid cognitive bias, we think of those pieces of the shape that we cannot see, and we make sure we are not inferring incorrectly.
Consider a farmer who wants to develop a bean to bar chocolate business. She has always dreamed of making chocolates with unique flavour profiles. She leases some land and sets about obtaining financing to plant cacao trees. For a person who has long-standing dreams, it is hard to evaluate a market with an unbiased eye. But avoiding a financial disaster is also critical to making a dream a reality. She researches market trends, transportation issues, shipping, global commodities markets, the local economy, the environment, the number of cacao farmers who are already working in an area.
By clearly assessing these parts of a new enterprise, without the cognitive bias that comes from hearing what we want to hear, this farmer may decide a better chance of success comes from developing a chocolate business using an already established farmer’s beans.
Cognitive bias is universal among humans, and is part of the way our brains process information and make decisions. Understanding and dealing with bias in decision making is a critical piece of financial literacy education, especially for those with limited experience in managing money.
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