Philip Chandler
Senior Technical Consultant
From the moment you wake until the end of the day, your life is a series of decisions. Indeed, University of Leicester research, reported by CNN, suggests that your brain makes more than 35,000 decisions every single day.
As a human, we’d like to think that every one of these decisions was entirely rational, as we weigh up all the options and act in our best interests. In truth, however, this is often not the case. Many of the choices we make are based on emotions – things like gut instinct or a “hunch”.
These emotions present one of the challenges to creating long-term financial security. Cognitive and emotional biases that impact your decision-making process can affect many different aspects of your life, including your finances.
Behavioural bias can mean that you make decisions that aren’t logical, and that hinder your progress towards your short and long-term goals.
A recent study reported by FTAdviser revealed that financial advisers believe investors’ emotional decision-making is costing them at least 2% each year in foregone returns.
Moreover, 63% of surveyed advisers say they are “frequently” or “regularly” surprised by the decisions or proposals their clients make about investments.
Luckily, there are many steps you can take to reduce the impact of bias, beginning with understanding what it is and how your emotions could be influencing your decisions.
Read on to discover five of the most common biases that could be guiding your financial decision-making.
1. Loss aversion
First posited by Amos Tversky and Nobel prize-winning psychologist and economist Daniel Kahneman, “loss aversion” suggests that the response to losses is stronger than the response to corresponding gains.
Indeed, studies reveal that you’d feel the pain of a £10,000 loss twice as sharply as the pleasure of a £10,000 gain. The consequence is that you end up being more cautious than necessary as you try to avoid losses.
In the FTAdviser study, almost half of financial advisers reported that the biggest investing mistake their clients made was “taking too little risk”.
Balancing risk and reward when making financial decisions can be difficult. If you decide to keep much of your wealth in “safe” assets, such as cash, you may find that you don’t achieve the growth necessary to reach your long-term ambitions. Additionally, your wealth could be losing value in real terms due to the eroding power of inflation.
Simply avoiding investments because you are concerned about the possibility of losing money can be just as detrimental to your long-term wealth as taking some risk.
Understanding your risk profile and creating a long-term investment strategy that you have confidence in is important for reducing the impact of loss aversion.
2. Herd mentality or “groupthink”
If you’ve ever made a decision on the basis that someone else is doing the same, you’ve likely experienced “herd mentality” or “groupthink”. Groupthink refers to the comfort you get from making certain decisions because other people are doing the same.
This bias may come from people you know or, often, from the media. You’ll have seen headlines about the “best companies to invest in” or the “dog funds to avoid” and it can appear as if everyone else is following this advice.
However, herd mentality means you can make the mistake of thinking investments are universally “good” or “bad”, when the truth is that the right approach for you will depend on your unique circumstances and goals.
While the investment that your colleagues or the Sunday papers are talking about may be right for some, it doesn’t automatically mean it fits into your wider financial plan.
Many investors in the US business GameStop found this out the hard way.
Back in 2020, a well-organised online group started buying shares in the struggling retailer. Their actions saw the share price soar, forcing institutional investors who bet against the company to back out. Between 8 December 2020 and 27 January 2021, the share price rose from $13.66 to more than $354.
However, those investors who joined the “herd” later and bought shares at inflated values would then have likely seen significant losses. At the start of August 2023, the GameStop share price was just over $21.
Simply following the herd is, in many ways, the opposite of our approach to financial planning. Your portfolio should be constructed based on your own unique goals and tolerance for risk, not what everyone else is doing.
3. The Semmelweis Reflex
In 1847, the Hungarian physician, Ignaz Semmelweis, made a significant medical discovery. Concerned at the level of deaths of “childbed fever” in the Vienna General Hospital, he realised that mortality rates could be significantly reduced if staff washed their hands between caring for patients.
He instituted a policy of using a solution of calcium hypochlorite for washing hands between autopsy work and the examination of patients. The result was the mortality rate declined by 90%.
However, the “germ theory” of disease had not been accepted in Vienna. His findings were largely ignored, rejected, or ridiculed. He was dismissed from the hospital for political reasons and harassed by the medical community, eventually leaving Vienna because he was “unable to endure further frustrations in dealing with the Viennese medical establishment”.
Of course, his discovery did, belatedly, gain widespread acceptance. Indeed, you can see Sir Mark Rylance portray the physician in the West End play Dr Semmelweis this summer.
So, what does this have to do with your financial decisions?
Investors can sometimes tend to reject new evidence or new knowledge because it contradicts the established norms or paradigms. So, when making decisions, it’s important to consider evidence over ideology. Don’t just accept established beliefs in the face of contrary evidence.
4. Hindsight bias
It’s likely you have looked back at a decision you have made with the benefit of hindsight and think that you would have done something differently.
Hindsight bias is a tendency to see the events you benefited from as predictable, whilst those that had a negative impact as unpredictable. The result is that you can end up feeling overconfident about your ability to predict what will happen whilst failing to learn from past mistakes.
Hindsight bias is a natural response to a past event in which you believe you knew the event would happen. You then associate that belief with new events, even when circumstances that can affect the outcome are different.
Discussing the event with a financial planner and analysing the surrounding circumstances while imagining alternate outcomes are just two ways you can avoid hindsight basis when making financial decisions.
5. Confirmation bias
When it comes to making a financial decision, you have probably already formed a preconceived idea about what is “right”. For example, you may decide to research whether investing in a specific fund or company is right for you but, in the back of your mind, you have already decided.
“Confirmation bias” means you are likely to actively search for information that backs up the ideas you already have. You also place more weight on sources that confirm what you already believe.
From an investment point of view, confirmation bias can mean you end up making decisions based on selected pieces of information that don’t give you the whole picture.
When making a financial decision, it’s important to understand a range of ideas and opposing views. That might mean consulting a range of news sources or working with a financial planner.
A planner can act as a sounding board, providing alternative points of view and helping you to arrive at a more considered decision.
