How to recognize biases to avoid financial mistakes.
It’s not always easy to make wise investment decisions, and this is especially true during uncertain times. When we’re stressed, we tend to make choices more intuitively and are less likely to spend time carefully sifting through all the pros and cons. The trouble is that intuitive snap decisions won’t necessarily help us meet our long-term financial goals.
Taking a moment to step back and work to understand the cognitive biases that may steer us in the wrong direction can help us make better decisions about our finances and reach the goals we are striving to achieve.
What are cognitive biases?
Cognitive biases are underlying belief systems that affect decision making. A long time ago, our ancestors’ brains evolved to create shortcuts to conserve energy and act fast in the face of danger. Back then, spending too much time considering a threat meant the difference between life and death. Today, our brains still use those ancient survival techniques, especially when we feel threatened by something, like volatility and falling markets.
Understanding our cognitive biases can help shed light on the choices we make about everything from whom we choose as friends to which job offer we accept to what we buy and how we invest. (See this video for a good explanation of the concept.)
A deeper dive on common biases
Behavioural economics is the study of how investors make decisions related to money. Research in this field has identified many biases that commonly influence the financial choices people make. Here are just a few.
The overconfidence bias comes into play when people overestimate their knowledge or abilities. In investing, they may think they understand the markets better than they do and that, if things don’t work out as expected, they will be able to escape bad outcomes. This bias can lead people to take on too much risk, hold overly concentrated portfolios and trade too frequently. It may also make people ignore advice from others, including professional advisors.
People generally feel the pain of loss more than the joy of gain, and this bias is known as loss aversion. It can cause people to keep money “safe” in a savings account that earns less than the rate of inflation, rather than investing in markets that can provide the potential for higher gains but also the potential for losses. As a result of this bias, investors can miss out on opportunities to build their wealth and achieve goals.
Illusion of control
When things feel chaotic, people often get anxious and look for ways to regain a sense of control. In response to feeling that they are powerless, people may decide that doing anything is better than doing nothing. This may lead them to ignore well-thought-out strategies and take unnecessary, irrational actions. Such actions can provide the illusion of control, but it isn’t real control, and it can derail long-term plans.
The representativeness bias is behind people’s focus on recent investment returns as an indicator of future performance. We tend to assume current market conditions, current headlines and even current weather can help make sense of the future – but what’s happening right now isn’t necessarily representative of what will happen next. Prioritizing too slim a sampling of data can lead to the wrong conclusions.
People tend to become attached to the first piece of information they get on a subject. That introduction becomes the anchor against which they evaluate all subsequent information. For example, let’s say someone encounters an investment on a day when it is valued at $10 per unit. If the investment rises to $20, it will seem expensive even if it’s still a good value based on underlying fundamentals. The anchoring bias can lead to decisions based on an impulsive first impression.
Overcoming biases with a trusted second opinion
Recognizing the biases that influence our decisions is an important first step – but even when we know they’re there, it can still be hard to sidestep them. Asking an advisor for a professional opinion can help promote rational, thoughtful, bias-resistant decisions and protect an investor’s ability to reach long-term financial objectives.
Specifically, an advisor can:
- Provide simple, precise, direct explanations and advice
- Outline the consequences of making (or not making) a decision
- Compare the potential outcomes of lower-risk and higher-risk strategies
- Make different plans for long-term and short-term assets
- Give concrete examples with real numbers to illustrate different scenarios
- Offer context and a far-sighted, long-term perspective
- Help connect investments to specific lifestyle goals
Financial decisions made today can have a profound effect on future financial well-being, so they need to be as well informed and unbiased as possible – even (perhaps especially) when times are tough and stress can interfere with decision making. Good advisors have clients’ best interests at heart and have likely spent a lot of time getting to know clients in ways that go well beyond their investment preferences, encompassing what they want out of life, what they love to do and the people who are most important to them. With that perspective, they can help guide clients towards better financial decisions.
So, before making a choice that affects your finances, speak to your advisor. That’s one decision you can count on getting right.