We take a look at four common biases traps that may derail you from realising your financial goals.
This information does not take into account your personal objectives, financial situation or needs. You should consider if the relevant investment is appropriate having regard to your own objectives, financial situation and needs.
Gain control over your relationship with money by waking up to the biases that you may be falling prey to.
Here, we’re going to cover a few common biases or cognitive distortions that can lead investors into making irrational and illogical financial decisions. As socially influenced, emotional creatures with limited self-control, we often behave irrationally, making decisions to our detriment. And when it comes to managing our money, this irrational behaviour can result in “self-sabotaging” our financial goals.
Fortunately, biases are predictable – a systematic error in our programming. This predictability means we can recognise our behavioural biases, understand where they come from, and hopefully overcome them (often by ‘re-biasing’ or using them to our advantage).
We hope by sharing these biases, you are empowered to recognise and stop them from derailing your plans.
“The investor’s chief problem – and even his worst enemy – is likely to be himself.” ― Benjamin Graham
Where do biases come from?
Biases are personal. They are formed by our own experiences including what we’ve seen or heard, actions we’ve taken, how our family, community and others have behaved around us.
Biases influence our behaviour in both conscious and unconscious ways, ensuring there is always a battle between intuition and logic.
We only began to understand how cognitive biases shape judgement around 50 years ago thanks to psychologists Daniel Kahneman and Amos Tversky.
Kahneman went on to win the Nobel prize for his work on prospect theory.
What are some of the most relevant biases in finance?
Prospect theory starts with the concept of loss aversion; an observation that people react differently between potential losses and potential gains – “losses loom larger than gains” (Kahneman & Tversky, 1979).
Essentially, the pain of losing is psychologically more powerful than the pleasure of gaining.
For example, if somebody gave you a $100 bottle of wine, we may gain a small amount of happiness (utility). However, if we owned the $100 bottle and dropped it, we would be more unhappy (I suspect we need to assume the dropped bottle was full).
In an investment context, an example of loss aversion is holding cash and choosing not to allocate it toward other (higher risk) investments. Some people feel safer with their money under the mattress (or in the bank), and this feeling outweighs any possible potential gain from investing their money in a logical fashion.
To combat loss aversion, try framing the situation as a potential gain. Another way to tackle loss aversion is to put things in perspective, possibly by asking yourself ‘what’s the worst that could happen?’.
Generally, not to getting too emotional about your investments and keeping a long-term view is useful.
The Anchoring Effect
The anchoring effect is a “systematic influence of initially presented numerical values on subsequent judgments of uncertain quantities”. In other words, showing someone a number can influence their estimate of the value of an unrelated item.
Take the example of the jewellery industry’s famously contrived ‘diamond anchor’. It suggests ‘two month’s salary’ should equate to the price paid for an engagement ring.
Logically, we know an engagement ring should be dictated by what an individual can afford, so the irrelevant anchor of the two-month salary only serves to maximise the profits of the jewellers.
In an investment context, anchoring is prolific in the stock market with the ‘price’ of something not necessarily reflecting intrinsic worth.
An investor may be fixated on a company’s recent ‘high’ stock price and consequently, believes the drop in price provides an opportunity to buy the stock at a discount.
To avoid anchoring, try to engage in more critical thinking by using a variety of benchmarks or perspectives.
Another bias playing out in our currently volatile economy is recency bias – it involves being “easily influenced by recent news or experiences”.
Recency bias is a cognitive bias where people tend to favour recent events over historic ones, even if they are not relevant or reliable.
I liken it to someone not wanting to go for an ocean swim after watching the movie Jaws, even though the risk of being attacked by a shark is nominal.
Recency bias may lead investors to think a stock market downturn or rally will extend into the future. In foreign exchange trading, traders have the tendency to look at only the most recent events, while disregarding older but equally important (or sometimes even more important) pieces of information.
A common culprit of inaccurate employee performance reviews, recency bias occurs when recent trends and patterns in behaviour and performance overshadow past actions.
This is a dangerous bias because milestones achieved at the beginning of the year should be factored into formal reviews as much as what happened last week.
The best way to combat recency bias is to try and take a step back and see the full picture. Again, reeling in your emotions to stay true to your long-term financial goals.
A close relative of recency bias is herd mentality – our intrinsic tendency to follow and copy what others are doing, under the assumption that they know more than we do.
We are wired to have a preference for the busy restaurant over the quiet one. Surely the food is better at the busier restaurant, right? As social animals, it’s not hard to see why we behave like this.
In the financial sector, investors may follow what they perceive other investors are doing, rather than relying on their own analysis. The herd mentality is what drives market bubbles and bursts, like those seen in the early 2000s.
It’s similar to the way animals react in groups when they stampede in unison out of the way of danger — perceived or otherwise.
It’s actually psychologically painful to be contrarian.
Those not following the herd may be fearful, but having a disciplined valuation framework for your investments can help keep your emotions in check.
Now you’re aware of some common biases, we trust this will help you to be more responsive, and less reactive to emotional factors.
Continue to reflect and educate yourself about your own particular biases, as this will ultimately help you to take back control of your relationship with money and help you to achieve the life you want.
For further reading, you can check out Kahneman’s book Thinking Fast and Slow. For those with less time, watch the BBC horizon documentary or read this frighteningly long list of cognitive biases.