Wednesday, March 5, 2008

Behavioral Finance – Bias from contrast-caused distortions of sensation, perception and cognition

This is the ninth in a series of posts about common human misjudgments. The series is based on a Charlie Munger speech at the Harvard Law School in 1995.

Why study human behavior in relation to finances?

Recognizing and understanding why people do the things they do, what drives them, and what are innately human tendencies is the first step in overcoming your own self and making sound decisions! We want to make rational, logical decisions, but emotions and irrational tendencies get in the way.

These behaviors are not all bad, many are good in some way - that is why they survived. In fact, these behaviors served some purpose that helped extend life at some time in the evolutionary process.

9. Bias from contrast-caused distortions of sensation, perception and cognition.

This one works every time! A great example is the real estate salesman. These folks know all the tactics – heck most all salesmen study this stuff. And you need to know it as well so that you can be on your guard.

Any time someone new strolls into town, the realtor immediately knows that he/she has a built in advantage. The first thing the realtor does is take the new folks out to tour a couple of the most awful, overpriced houses on the market. This warps the buyers perception. Since they are new in town and they do not know what to expect and being friendly people eager to find a new home they trust this salesman. Then the realtor takes the folks out to some moderately overpriced house and sticks it to them. This last house looks so much better and at a lower price than the others that they actually believe it’s a good deal.

Why are we so vulnerable to this ploy? It seems that if information comes to us in small pieces, we're likely to miss. So, if you're going to be a person of good judgment, you have to do something about this warp in your head where it's so misled by mere contrast.

Fortunately, today we have access to a lot more information via the internet. You can check prices on most anything before ever stepping into a store or touring houses in a far away location. It’s an awesome tool that helps you become more informed and make better decisions.

For more on PF, please check out the Carnival of Money Stories at Piggybankblues . My article “What would you do with $100,000?” was included this week!

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