Behavioural Biases…

Why is it easy to make financial mistakes, and how to prevent them?

Humans are complex and emotional beings and there are factors at play that can cloud our rational judgement and decision making.

Unfortunately, making one poor investment or planning decision can lead to making another, making the end goal much harder or even impossible to reach.

Thankfully, decision making has now been widely studied and the research provides some insight to help make better choices. We know this as ‘Behavioural Finance’ when making financial decisions and it is split into two parts: emotional biases and cognitive errors.

Emotions play a significant role in decision-making. Fear and greed are two strong emotions that can influence investors. Fear can lead to panic selling during market downturns, while greed can drive excessive risk-taking when market cycles are peaking. Both lead to less-than-optimal outcomes.

The human brain is hugely powerful and has immense processing capabilities. But this can lead to mental shortcuts to simplify complex decision-making, causing some information to be ignored or altered to fit a simpler explanation. These are cognitive errors.

At Engage we use our knowledge of these biases to help clients make better financial decisions and help them understand some of the challenges that are part of the decision-making process. The aim is to avoid common mistakes, promote better behaviours and improve financial outcomes.

Below we’ve outlined just some of the most common emotional biases (E) and cognitive behaviours (C) that we see and why they can have negative impacts.

Loss Aversion

Investing is required to grow existing wealth so that it has more purchasing power in the future. Some investors however are more worried about avoiding losses than making gains, which is loss aversion (E). This can lead to taking on different types of risk i.e. ignoring the risk of inflation and accepting suboptimal investment returns, rather than investing in assets that can beat inflation over the longer term. This is also evident when investors hold on to loss-making investments for too long in the hope they will eventually go back up.

Confirmation Bias

Another more well recognised bias is Confirmation bias (C). People like watching or hearing views that agree with their own and confirm their pre-existing opinions, and usually ignore or undervalue evidence that disagrees with them. This is an important bias to acknowledge, and recent world events have shown this to be true. From an investing perspective, this can lead to investors being under-diversified or holding a disproportionate investment in a few companies or invest in an industry (sector) they work in.

Overconfidence Bias

Similar approaches to investing are caused by overconfidence bias (E). Being too sure about one’s own ability to predict outcomes can also lead to underestimating risks, over-estimating potential returns and excessive trading. It’s very normal for people who are successful in other walks of life to think they can repeat their success in investing without fully understanding how difficult it is.

Hindsight Bias

Confidence also plays a part in hindsight bias (C); past events appear predictable, and this creates a false sense of confidence that future events can also be predicted. This is a common subconscious bias. People often look back with rose tinted glasses and this can cause new opportunities to be missed.

Status Quo Bias

Sometimes a lack of confidence or lethargy to make change is evident with status quo bias (E). This has nothing to with the legendary 60s - 80s rock band, and everything to do with preferring to leave things as they are, even if it is clear that a change would improve things. This can result in people not making the requisite adjustments in their lives to bring about the changes they need. We see prospective clients with investment portfolios that haven’t evolved over time and have drifted from their required objective and see evidence of missed opportunities from not utilising allowances or not making required investment tweaks.

Mental Accounting and Endowment Bias

Another barrier to making positive changes is mental accounting (C). Savings from salary might be thought of differently to saving bonuses or inherited money. This can lead to disjointed, unstructured investing, and investing in or drawing from funds in less tax efficient ways, causing sub-optimal financial outcomes. Endowment bias (E) can be similar. Assets that are already owned often carry more emotional value and investors can struggle emotionally to sell assets or replace them once already owned. We aren’t saying that all inherited assets should be sold but it is good to be aware that ‘cherished’ holdings can cause investors emotional anguish.

Availability Bias and Framing Bias

As humans, we are fully aware that we are susceptible to advertising and the way in which information is presented. Advertising and popular trends (fads) can be responsible for availability bias (C). This is the perception that if it comes to mind quickly it must be good or the most likely outcome or option. This can contribute to market bubbles, or investment selections that aren’t based on analysis. Advertisers also know which buttons to press (or not press). Research shows that presenting the same or similar information in different ways leads to different choices being made; framing bias (C). Investors react differently to being told there is a 20% chance of loss compared to being told there is an 80% chance of making a gain. Perhaps obvious but this is something that can lead to making poor choices.

Recognising what influences human decisions can help challenge inbuilt biases, avoid common mistakes, promote better behaviours and improve financial outcomes.