Despite what we may all think, we’re not always the most rational animals. Everybody comes with their own behavioural biases and these can affect how we make decisions, including those about our finances.
Often, we can be steered by how we feel rather than by cold, hard facts. So, understanding and acknowledging that biases exist can be useful when we need to act in certain situations.
Making knee-jerk, emotional financial decisions can have a devastating impact on your long-term plans or goals. So, to help you, here are seven common behavioural biases that you should look out for.
1. Loss aversion
Demonstrated by Amos Tversky and Daniel Kahneman in 1992, the idea behind loss aversion suggests that the pain of losing is psychologically more powerful than the pleasure of gaining – indeed we feel losses twice as powerfully.
Here’s an example.
You are offered a guaranteed payment of £900 or a 90% chance of winning £1,000 (and a 10% chance of winning nothing). What would you take?
Most people avoid the risk and take the £900, even though the expected outcome is the same in both cases.
But what if you were asked to choose between losing £900 and taking a 90% chance of losing £1,000 (with a 10% chance of losing nothing)?
Here, most people would prefer the second option, with a 90% chance of losing £1,000. They take a riskier decision in the hope of avoiding a loss.
When making investment decisions, individuals often focus more on the risks associated with an investment rather than on the potential gains. This can be magnified when focusing on an investment that has lost money and ignoring others.
2. Familiarity bias
As humans, we tend to assume that previous behaviour and its outcomes can be applied to new situations. We believe that what worked in the (very different) past will work now and in the future.
This bias is about habits that we need to give up. In this sense, we are ‘victims’ of our past. It also explains why people learn more from failure than from success.
If we don’t remodel our prior learning to the current context, the same negative outcomes can occur.
3. Herding bias
How often have you considered doing something because ‘everyone else is doing it’?
We often rationalise that a course of action is the right one because it’s what everybody is doing. These days it is known as ‘fear of missing out’, or FOMO.
Herding can be part of the reasons for strong stock market rallies (everyone is buying) or sharp market declines (everyone is selling).
Thinking independently and basing decisions on our principles and values is a good approach and can keep us grounded, particularly in uncertain times.
4. Overconfidence bias
As we saw above, people often learn more from failure than from success. So, investors who have enjoyed a run of good luck can become overconfident or naively optimistic.
At the other end of the spectrum, some investors have enjoyed such bad luck over the years that they end up at the opposite extreme where they can’t function rationally. They may end up hugely risk-averse, with money in low-interest cash savings that don’t even keep pace with inflation.
While all extremes of confidence are bad, if you are overconfident, it can be a symptom of a failure to learn and adapt.
5. The Dunning-Kruger Effect
This term comes from a 1999 research paper authored by Justin Kruger and David Dunning and illustrates that we frequently overestimate the abilities of our intellect.
We constantly process new information, much of which is new to us, and this can lead us to over-inflate our abilities or ‘expertise’ on a subject, especially one that we have only just begun learning about.
Today’s technology is perpetuating this bias as we’re increasingly able to insulate ourselves by curating our own news and research. We have a tendency to seek out information that only serves to reinforce our beliefs and, when we limit the scope of information relating to an investment choice, we risk missing critical signals.
6. Fluency bias
This is a simple theory that suggests we prefer information that we can process easily. Ideas and theories which we can process faster therefore appear to have higher value.
Researchers have found that shares with fluent and easily pronounceable names outperformed non-fluently named stocks. The authors based this finding on the concept of ‘fluency’, and that fluently named stocks are considered to be more valuable due to the ease with which they are processed.
7. Probability neglect
Probability neglect is the human tendency to disregard probability when deciding something in uncertain circumstances.
In uncertain times, we become much more emotional and our decisions are increasingly based on emotionally led (rather than factually led) opinions. If you suffer from probability neglect, then you are likely to underplay the positive and overinflate the negative, such as thinking the stock market may never recover.
Get in touch
In recent years, financial planners have increasingly developed a ‘coaching’ role. Our job is partly to help you to avoid making rash or emotional financial decisions which you could later regret.
To find out how we can help you to keep your financial plan on track, please get in touch. Email firstname.lastname@example.org or call us on 01189 876655.