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Are you following the science?

The expression “following the science” has become a bit of a tired old trope in recent months, but that shouldn’t detract from the fact that the scientific method has helped to enrich our lives.

In the financial world, it’s social sciences that offers some valuable insight into how we behave when it comes to money. And it probably comes as no surprise, but studies in Behavioural Finance, as it’s known, suggest we might not be as rational as we think we are.

The following are just a seven of the many psychological and emotional biases that we all battle with when making financial decisions.

Which of these strike a chord with you?

 

Loss aversion

You know that sinking feeling you get when you lose money or anything that’s really important to you?

It’s painful. From an evolutionary point of view, losing something of value might reduce your chances of survival so we’re conditioned to try to utmost to avoid that feeling. This would have been a very helpful physiological nudge in caveman times but not so much when it comes to managing emotions around investing. In fact, the remorseful feeling that accompanies loss is estimated to be twice as powerful as the good feelings generated by gains.

And for many, their financial strategy can often hinge on a fundamental financial choice that directly challenges loss aversion:

Option 1 – invest to achieve the higher returns needed to maintain your lifestyle in the future. The price of your investments might fluctuate from time to time, but the end result tends to justify short periods of pain.

Option 2 – invest overly cautiously and end up with lower returns. Your money will feel safer, but you may well guarantee a reduction in your long-term standard of living.

Left unchecked, an uncomfortable number of people will opt for 2, even though option 1 carries very reasonable odds of achieving what they really want for their lives.

When has loss aversion caused you to play it too safe?

 

Confirmation bias

When we hold a particular belief or conviction, our mind isn’t naturally open to being changed. In fact, we’ll often subconsciously filter out information that might conflict with or disprove our beliefs.

A client recently told me how his parents had to delay their retirement by nearly ten years due to some pension investments that had gone south. From this, the client formed the belief that pensions were very risky and a series of high-profile pension scams only seemed to reaffirm this to him. Pensions were firmly off the menu for this client.

After further discussion, it materialised that his parents had invested their pension funds in a handful of small company shares – a very risky and speculative strategy in anyone’s book. The problems therefore arose from their investment choices rather than the fact the money was in a pension wrapper. With this fresh perspective the client was more open to a discussion about the potential benefits of pensions.

It can be very hard but reminding yourself that beliefs are not facts helps you to see possibilities rather than problems.

What beliefs or experiences might have clouded your financial judgment?

 

Availability bias

The availability and prominence of information also has a big impact on our decisions and opinions. Recalling information quickly is useful when you need to make a choice without too much thought, but only if the source is reliable.

News headlines and sub-headlines are a great example of this. The way messages are conveyed is so easy to digest and retain that, oftentimes, it’s these that shape our judgments rather than the detail in the body of the article (if we even make it that far!).

With market news in particular, the words down, fall and loss are given so much more prominence than up, rise and gain that your subconscious may have little choice but to form a negative judgment about the state of markets (and may trigger loss aversion).

As the ever-quotable Warren Buffet’s famously said, “don’t buy or sell on headlines”.

How does the way you consume information affect your judgment?

 

Anchoring

One of my favourites! I often see this in relation to people who’ve bought individual shares.

A friend of mine invested in the shares of a major high street bank in 1999 when they were around £5 per share. More recently, the share price has averaged £6.50 which, when you think about it, isn’t a great return over 20 years.

But he just flat-out refuses to sell them because at one point in time, the share price touched £10 – this happened way back in 2006!

There’s no evidence to suggest they’ll ever get back to that level but in my friend’s mind, his anchor point is the magical £10 figure so if he sold the shares before reaching this price, he feels he’d be making a loss. This is also linked to another bias where we over-inflate the value of something just because we happen to own it (very common when people value their home).

Anchoring, inertia and avoiding the feelings of regret mean that a lot of people will hold on to dud investments for far too long. There’s no shame in selling up and recouping your losses via an alternative investment.

What investments are you clinging on to without good reason?

 

Mental accounting

This is about how we classify and attach emotional value to different pots of money.

In its most helpful form, it can provide us with much-needed financial discipline i.e. allocating different pots for different financial purposes.

But mental accounting can also go against you.

A client due to shortly retire had long ago mentally committed to cashing in his pension at retirement to provide income.

For tax reasons, it made so much more sense to use other financial resources first (cash in the bank) but he’d attached himself to this strategy for so long it was very hard for him to consider an alternative. It took a lot of convincing, but we got there in the end!

Which of your pots have “labels” and how do you know these are right?

 

Confidence

Overconfidence encourages enterprise and moves the world forward. But it can also seduce us into over-estimating our abilities or level of control in particular matters.

This can see us make financial decisions based on gut feeling alone. And it can even cause us to take unnecessary risk because we attribute past successes to our own skill and downplay the role of good fortune or lucky timing.

Likewise, lacking confidence in our own judgement can mean we don’t take enough risk for fear of making a mistake or having to deal with those feelings of loss or regret.

 When did you take credit (or blame) for something that wasn’t in your control?

 

Projection bias

This is where we make the mistake of thinking that our needs, preferences and circumstances in the future will be the same as they are today.

It can cause people to under-estimate the amount of money they might need for retirement (people expect their costs to reduce – it’s often the opposite) and how long this needs to last.

It can also mean that we might not make adequate insurance provisions for unforeseen events like death or illness because we assume we’ll always be fit and healthy.

What things might be different for you in the future? What could impact your lifestyle?

 

What to do about biases

There are many more biases that come into play but the starting point is to develop awareness about the ones that affect you most. Resources like the BEAM App are incredibly useful for this – for Apple users, it’s available on the App Store: https://apps.apple.com/gb/app/beam-self-awareness/id1473246949

As with any ingrained psychological or emotional dynamic, changing it requires an unnatural level of introspection, self-analysis and objectivity. This doesn’t come easy for most, so a sounding board (like an independent financial adviser, for example) can help you identify and resolve biases that might be impeding your financial progress.

If you have any questions or need help following the financial science, please don’t hesitate to get in touch.

Stay well.

Simon