June 23rd, 2020
5 behavioural biases that could be affecting your financial decisions
While we may think of ourselves as rational creatures when it comes to our finances, it’s common for emotions to take over our decision-making. Much research has been done into the link between emotions and investing, and experts have established a range of cognitive biases that come into play when we make decisions about our money.
To help you avoid making knee-jerk emotional decisions that could damage your financial security, it’s important to be aware of these biases. Here are five of the most common.
1. Loss aversion
Behavioural science experts Amos Tversky and Daniel Kahneman developed the theory that, for individuals, the pain of losing is psychologically twice as powerful as the pleasure of gaining.
In their experiment, an individual was asked if they would make a bet based on the flip of a coin. If the coin came up tails, the person would lose $100. If it came up heads, they would win $200.
The results showed that, on average, the potential gain needed to be about twice as much as an individual was willing to lose in order to accept the bet.
So, when you are faced with an investment decision, you will typically have a stronger preference for avoiding possible losses than for making gains. Loss aversion can manifest itself in several ways when it comes to investing:
- Deciding to invest in ‘safe’ products that offer little or no return (or often lose money in real terms when the effects of inflation are considered)
- Selling shares because they are worth more than you paid simply to lock in a profit, rather than being patient and holding them for a longer period that might see further gains
- Not selling investments that have fallen in value because you don’t want to take a loss.
2. Representativeness bias
Representativeness bias occurs when the similarity of events confuses your thinking regarding the probability of a certain outcome. Individuals often believe that two similar things are more closely correlated than they actually are.
In financial markets, an example of representative bias is when analysts forecast future results based on historical performance. Just because a company has seen high growth for the past five years doesn’t necessarily mean that trend will continue indefinitely into the future.
As an investor, it can pay to keep an investment diary. Write down your reasoning and then match it to the outcomes, whether good or bad.
3. Anchoring bias
Anchoring bias happens when an individual relies too much on the first information they see when making decisions.
For example, if you see a tin of beans that costs £100, then see a second one that costs £10, you are prone to see the second tin as cheap. However, if you’d just seen the second tin of beans at £10, you would probably view it as incredibly expensive.
The ‘anchor’ – the first price you saw – unduly influenced your opinion.
If you were asked where the Tesco share price would be in three months, you’d probably look first at where it is today, then predict where it will be in three months. This is a form of anchoring bias as you start with a price now and build a sense of value based on that anchor.
4. Self-attribution bias
Sometimes humans tend to attribute good outcomes to our skill and bad outcomes to luck. This self-attribution bias means we choose how to attribute the cause of an outcome based on what makes us look best.
When our investments go up, we think that it’s due to our investing skill. When they don’t, we believe it to be bad luck.
One of the most effective ways to tackle this bias is to record and recognise what happened, documenting the reasoning behind your decisions and the outcomes that followed. Billionaire George Soros, along with many other famously successful investors, extols the value of recording, reviewing, and analysing investment decisions.
Only through admitting and examining our mistakes that we can learn from those mistakes. And it’s only when we recognise that we have fallen victim to things such as the self-attribution bias that we can learn to avoid these traps in the future.
5. The Semmelweis Reflex
In the mid-1800s, Hungarian obstetrician Ignaz Semmelweis discovered that ‘childbed fever’ could essentially be eliminated if doctors washed their hands before they assisted with childbirth.
He initiated strict rules at his hospital where everyone involved in childbirth had to first wash their hands with a chlorinated solution. As a consequence, death rates plummeted.
The expert expected a revolution in hospital hygiene because of his discovery. However, it never happened. This is because his hypothesis – that there was one cause of disease that could be easily prevented – ran counter to the prevailing medical ideology, which insisted that diseases had multiple causes.
Eventually, Semmelweis was dismissed from his post and discredited by the medical community. He was forced to move from his home in Vienna and eventually died in a Budapest asylum.
In a financial context, the Semmelweis Reflex explains that investors often reject new evidence or new knowledge because it contradicts established norms or beliefs.
To avoid this bias, it’s important that you consider evidence over ideology or your own personal beliefs. Don’t just blindly accept established norms in the face of contrary evidence.
(Incidentally, if you want to learn more about Semmelweis’ extraordinary life, Oscar-winner Mark Rylance will be playing the Hungarian in a brand-new production at the Bristol Old Vic in 2021).
Get in touch
One of the benefits of working with a financial adviser is that they can act as a sounding board and a mentor when it comes to making financial decisions. They can help you to avoid emotional choices that could severely damage your long-term financial goals.
To find out how we can help you, please email firstname.lastname@example.org or call 01562 829 222.