Every day we make financial decisions, but you’ve probably spent little time thinking about the thought process that goes on behind each one you make. After all, we’ve evolved to make our decision-making processes quicker and easier.
While you may quickly decide whether a purchase is good value for money or to deposit savings into an account, there’s a lot that goes into it. The decisions we make, including those related to finance, are based on experiences, information we’ve stored, our general perception of the world and more. It means we can make decisions incredibly fast, but it can also lead to cognitive bias. This leads to subjective views shaping actions rather than objective ones.
Even two people experiencing the same event can interpret and react differently, based on their own bias. In terms of finance, that means we could be making decisions that aren’t right for us, based on a news story we’ve read, a past experience or a perception of what we should do.
The study of psychology has found numerous ways bias affects decisions, many of which influence how we use our finances. Below are just three examples of this:
1. Confirmation bias
This is where we seek evidence to support the views we’ve already established and discredit those that contradict them. In the information age, it’s not hard to find something that will support an action or view. It means that you could be filtering out potentially useful information because you subconsciously ignore facts that refute the opinions you already hold.
From a financial perspective, it can have a significant impact. Take investing for example: If you have heard that a particular investment will outperform others and when searching for further information you only read the news stories that support this, you could miss vital data that suggests the opposite. In turn, this could mean you make a riskier investment decision than you normally would.
2. Familiarity bias
We’re often creatures of habit that prefer to be familiar with the decisions we make. As a result, we can tend to actively seek out those options that are familiar, even when trying something different could yield more positive results.
Again, from an investment perspective, this can lead to an investor placing their money into a fund or market that they’re already exposed to. While familiar investments can feel like they add security, it isn’t always the logical option and diversification could help minimise volatility in your portfolio.
3. Negativity bias
We often tend to place greater importance on negative experiences, and these are the ones that are more likely to stick in our mind. A look at newspaper headlines highlights this; you’ll often find numerous stories that focus on the bad in the world, even when the negative events are far rarer than the positive. Psychology suggests that this sensitivity is part of our survival instinct.
It’s a bias that can lead to us taking a more cautious approach when it comes to our finances and, in some cases, not taking steps we should be. For example, if you’ve read several articles on how pension schemes are collapsing, returns aren’t as expected, or that they’re failing to deliver the income needed, you may be less inclined to put more of your disposable income into a pension scheme, even if you could benefit in the long term.
These three examples demonstrate how bias could be affecting your financial security and the decisions you make. So, with this in mind, what can you do about it?
The first step is realising that bias naturally happens. This allows you to take action to reduce how much bias affect your decisions. From spending time researching both sides of an argument to objectively looking at your own experiences, understanding bias can improve outcomes. This is also an area that financial planning can help with.
How can financial planning help remove bias?
Perhaps a past investment underperformed and you lost money, putting you off building your portfolio now. Investments do carry risk, and the value (and any income from them) can go down as well as up. There are no guarantees and past performance should not be relied upon, However, a financial planner will be able to show you how markets have performed, projected returns, and explain the associated risks. Armed with the right information and a balanced approach, you’ll be in a better position to make decisions that limit the influence of personal bias.
If you’d like the support of a financial adviser, please contact us. We’re here to help you make decisions based on facts to create a strategy that is logical for you and your aspirations.