When you’re making large financial decisions, basing them on facts and logic could help you choose the option that’s best suited to your needs. Yet, even when you take this approach, cognitive biases may affect the conclusions you draw.
Over the last few months, you’ve read about how past experiences and emotions might affect your financial decisions. Now, read on to find out more about cognitive bias.
Cognitive bias refers to processing errors that might arise from problems with your memory, attention, attribution, or other mental mistakes.
Lots of different factors can affect how you think from your attention wandering if you’re feeling stressed about something else to mental shortcuts known as “heuristics”. Cognitive bias happens to everyone, so read on to discover how it could affect your financial decisions.
1. Confirmation bias
Researching your options when making an investment decision is important. However, confirmation bias might mean you don’t give new information the attention it deserves.
With this bias, you’d favour data that corroborates your pre-existing belief. So, if you already believe that a particular investment opportunity is right for you, you’ll seek out information that supports this view. It could mean you dismiss vital details because it contradicts what your mind has already decided.
By focusing on information that confirms your belief, you may end up making investment decisions that aren’t appropriate for your goals or financial circumstances.
2. Anchoring bias
Anchoring bias occurs when you rely too heavily on a single piece of information, so your views are “anchored” when making decisions.
When you’re investing, the anchor might be the first piece of data you see, such as the value of a stock or share, or you might focus on it because of where it’s come from, like a trusted friend.
Tethering your decisions to a piece of information that might not be relevant can be damaging.
For example, as an investor, you may anchor how you value a particular investment to the price you initially paid for it rather than assessing its current or future value. This could mean you’re more likely to hold on to an investment even if that doesn’t align with your wider investment strategy.
Anchoring bias could lead to you avoiding new opportunities or failing to make changes because you’re focused on a particular data point instead of looking at the bigger picture.
3. Framing bias
How opportunities are presented to you could affect how you perceive them.
Imagine you’re talking to a friend about an investment. If they say there’s a 20% chance that you’ll lose all your money, you’re likely to start worrying about how the loss could affect your finances. On the other hand, if they said there’s an 80% chance of success, it can sound far more appealing.
Even though both statements convey the same chance of success and failure, they can lead to very different outcomes. You may be more likely to make riskier decisions if it’s communicated to you in a positive way that focuses on potential gains.
4. Sample size neglect
Researching financial options can feel overwhelming, whether you’re looking for the best way to invest or are seeking financial protection, as there’s often a lot to weigh up. One shortcut that could lead to bias is basing your decisions on a small sample size.
If you’re looking for the best account for your savings, you might ask family or friends and follow their advice. However, what’s right for them, might not be suitable for you, and if you researched your own options, you could find that a different account is better suited to your needs.
Alternatively, you might review investments and see that a particular sector has performed well over the last few months, so you decide to move more of your money into this area. Yet, as you’re basing a decision on short-term figures, you could miss out on wider trends and inadvertently increase the financial risk you’re taking.
Sample size neglect may lead to overconfidence in predictions that are based on limited experiences.
5. Loss Aversion
Loss aversion is similar to framing bias as it’s about how you perceive losses and gains.
The theory suggests that you feel losses more keenly than you do gains. So, if your investment portfolio falls by 5%, it would affect your emotions more than if it had increased by 5%.
For some investors, this cognitive bias could lead to them becoming risk-averse and potentially missing out on opportunities, even if they’re appropriate for them. A cautious approach may seem “safe”, but it has the potential to harm your long-term wealth creation and affect your plans.
An outside perspective could help you limit the effects of bias
It can be difficult to recognise when bias might be affecting your decisions. Sometimes an outside perspective could help you identify where past experiences, emotions or cognitive errors are influencing the conclusions you’ve drawn.
As financial planners, we can work with you to create a financial plan that aligns with your goals and circumstances. Please get in touch if you’d like to arrange a meeting.
Please note:
This blog is for general information only and does not constitute financial advice, which should be based on your individual circumstances. The information is aimed at retail clients only.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.