Traditional economic theory assumes that when making decisions people act rationally to maximise their benefit. However, behavioural economics challenges this notion by demonstrating that human decision-making is frequently irrational and influenced by a variety of cognitive, social, and emotional factors that we are often not conscious of. 

One of the key concepts in behavioural economics is bounded rationality, which suggests that individuals are limited in their ability to process information and make fully rational decisions. Instead of considering all available options and outcomes, people often rely on mental shortcuts to make decisions. While these shortcuts can be useful, they can also lead to errors or biases. 

Here are some detailed examples of these biases so that you can identify them and make better decisions.  

1. Anchoring 

Anchoring occurs when individuals rely too heavily on an initial piece of information (the “anchor”) when making decisions. For example, if a person sees a jacket priced at $1,000 and then sees another one at $200, they may perceive the second jacket as cheap, even if $200 is still expensive for a jacket. The initial $1,000 price serves as an anchor that skews their perception of value. 

2. Overconfidence bias 

Overconfidence bias is when individuals overestimate their knowledge, abilities, or the precision of their information. This can lead to overly optimistic decisions. For instance, based on a few fortunate trades, a stock trader might believe they can predict market movements better than they actually can. This can lead to risky investments and potential losses. 

3. Confirmation bias 

Confirmation bias is the tendency to search for, interpret, and remember information in a way that confirms one’s preconceptions. This can result in poor decision-making as individuals might ignore or undervalue information that contradicts their beliefs. For example, a manager might only consider positive feedback about a new strategy they support, ignoring critical insights that suggest potential flaws. 

4. Herd behaviour 

Herd behaviour describes the tendency for individuals to mimic the actions of a larger group, often ignoring their own analysis or the fundamentals of the situation. This is common in financial markets where investors might follow the majority in buying or selling stocks, leading to bubbles or crashes. The 2008 financial crisis saw significant herd behaviour as investors collectively underestimated the risks of subprime mortgages. 

5. Framing effect 

The framing effect occurs when people react differently to the same information depending on how it is presented. For instance, a surgery with a 90% survival rate might be perceived more favourably than one with a 10% mortality rate, despite the statistics being equivalent. The positive frame leads to a more favourable decision. 

6. Sunk cost fallacy 

This bias happens when individuals continue investing in a decision based on cumulative prior investments (time, money, effort) rather than future benefits and costs. For example, a person might continue funding a failing project because they have already invested significant resources, even if it is rational to cut losses and move on. 

7. Status quo bias 

Status quo bias is the preference for the current state of affairs. People tend to resist change and prefer things to stay the same. This can lead to suboptimal decisions, such as sticking with a less efficient technology or product out of reluctance to change. 

8. Availability heuristic 

The availability heuristic leads people to overestimate the likelihood of events based on their availability in memory. Events that are more memorable, often due to their dramatic or recent nature, seem more common than they are. For example, after seeing news reports about airplane crashes, an individual might develop an irrational fear of flying, despite statistical evidence showing its safety. 

9. Prospect theory 

Prospect theory highlights how people value gains and losses differently. A loss is felt more acutely than an equivalent gain (loss aversion). For instance, losing $500 feels more painful than the pleasure of gaining $500. This can result in risk-averse behaviour when facing potential gains and risk-seeking behaviour when facing potential losses. 

10. Endowment effect 

The endowment effect describes how people ascribe more value to things merely because they own them. For instance, someone might demand a higher price to sell a car they own than they would be willing to pay to buy the same car, purely because of their ownership. 

Understanding these biases and taking steps to mitigate them, such as seeking advice from a professional, will lead to better decision-making. To learn more, talk to one of our advisors on (02) 6686 6678.