The way in which our brains process information is subject to bias. This is very much the case with respect to financial decision making.
In my experience as a financial adviser and money coach, one commonality with regards to how people behave with their money is that – no two people behave exactly the same way!
There are many reasons for this, but cognitive bias goes to explain a large part of it.
What is a financial bias?
A financial bias refers to a systematic error or deviation from rational decision making in financial decision making. These biases are cognitive and emotional tendencies that lead us to make decisions that are not in our best financial interest.
Financial biases can be rooted in personal experiences, beliefs, social norms, or psychological factors, and they can manifest in different ways.
How do they affect our financial wellbeing?
These biases can cause us to miss out on opportunities, take on too much risk, or make impulsive decisions that are not in our long-term financial interest. They can lead to us spending more than we should or saving less than we need.
Being aware of these biases is the first step in managing our finances more effectively.
What are some examples?
Here are 5 common biases that influence decision making around money.
1. Loss Aversion Bias
Loss aversion bias is the tendency for people to avoid losses rather than seeking gains. This means that we feel the pain of losing money more acutely than we feel the pleasure of gaining it. Loss aversion bias can make it difficult for us to take risks, such as investing in the stock market.
Loss aversion bias can manifest in a variety of ways. For example, it can cause people to hold on to losing stocks for too long, in the hope that they will eventually recover. This can result in significant losses over time. It can also cause people to avoid investing altogether, missing out on potential gains in the stock market.
To overcome loss aversion bias, it is essential to focus on the potential gains instead of the potential losses. It’s important to consider the long-term benefits of investing in stocks, and to remind ourselves that market fluctuations are normal. One strategy is to set up automatic contributions to a retirement account, so you don’t have to think about it. This can help you focus on the long-term benefits of saving for retirement rather than the short-term pain of losing money.
2. Confirmation Bias
Confirmation bias is the tendency to seek out information that confirms our pre-existing beliefs. This can lead to bad financial decisions because people may only seek out information that confirms what they already believe, rather than seeking out a range of opinions.
Confirmation bias can be particularly problematic when it comes to investing. People may only seek out information that confirms their belief in a particular stock or investment strategy, rather than considering a range of viewpoints. This can result in missed opportunities or significant losses over time.
To overcome confirmation bias, it’s essential to seek out multiple sources of information before making a financial decision. We need to challenge our assumptions and seek out alternative viewpoints. This can be particularly important when it comes to investing, where there is often a range of opinions on the best strategy to follow.
3. Anchoring Bias
Anchoring bias is the tendency to rely too heavily on the first piece of information we receive when making decisions. This can be particularly problematic when it comes to pricing. For example, if we see a sale sign that says “50% off,” we may feel like we are getting a good deal even if the original price was overpriced.
Anchoring bias can also lead people to hold on to investments that are no longer performing well, in the hope that they will eventually recover. This can result in significant losses over time.
To overcome anchoring bias, it’s important to do your research before making a purchase. Look up the prices of similar items and compare them to the sale price. This will help you determine whether you are actually getting a good deal. It’s also essential to avoid impulse buying and take the time to consider your options.
4. The Halo Effect
The halo effect is the tendency to attribute positive qualities to a person or product based on a single positive trait. For example, we may assume that a car is high-quality because it has a luxury brand logo, even if the car itself is not actually well-made.
The halo effect can also lead people to invest in a particular stock or investment based on a single positive news article, without considering other aspects of the investment.
To overcome the halo effect, it’s essential to do your research and not make decisions based on one positive trait alone. We need to look at multiple aspects of a product or investment before making a decision. It’s also important to consider the potential downsides or risks of a particular investment before investing in it.
5. Present Bias
Present bias is the tendency to prioritize short-term pleasure over long-term benefits. This can lead to overspending and not saving enough for the future.
Present bias can manifest in a variety of ways. For example, people may choose to spend money on a vacation rather than saving for retirement. They may also prioritize buying material possessions over saving for a down payment on a house.
To overcome present bias, it’s essential to focus on the long-term benefits of saving for the future. We need to create a budget that allows us to save for both short-term and long-term goals. We can also try to find ways to make saving more enjoyable, such as setting up automatic contributions to a savings account or rewarding ourselves when we reach a savings goal.
Managing Bias
Our behavior with money is heavily influenced by cognitive biases. We can’t get rid of bias, but we can adjust for it when it comes to the decisions we make around money.
The level and degree to which our bias needs to be managed is an individual thing, and may depend on the size and importance of the decision being made.
For example, if you are considering the degree to which anchoring bias impact may be impacting your decision to buy a new toaster on sale vs the pleasure bias of an expensive luxury overseas holiday – you may be inclined not to get too hung up on the former!
Ultimately, being aware of these biases and taking steps to overcome them is essential for managing our finances effectively.
Some other successful strategies for managing bias may include:
- Focusing on the potential gains rather than the potential losses,
- Seeking out multiple sources of information when making a big purchase
- Avoiding impulse buying, instead taking your time to come to a decision
- Doing your research, and exploring options
We can improve our financial situation and reach our personal financial goals simply by being aware of how bias affects our decision making at the time of making a decision so that we can make adjustments where necessary.
