Everyone suffers from some form of cognitive bias — a kind of shortcut thinking. Some studies suggest that a person can be subject to over 1751 cognitive biases in their day-to-day decision-making.
When it comes to financial planning and investments, cognitive biases can result in some costly blind spots or avoidable losses. To check if you are guilty of autopiloting your thinking, start by asking yourself how you go about making important decisions.
Do you:
• Do your own research?
• Make a pros and cons list?
• Consult a friend, or an expert?
Our brain tends to have certain cognitive biases, or ‘flaws in our reasoning’, which influence our judgment in terms of the information we focus on, how we remember decisions made in the past, or even the sources we rely upon for our research. A cognitive bias often leads to people deriving conclusions inaccurately, generally due to the misinterpretation of information.
How do these findings affect the average person planning financial or investment goals? And importantly, are your decisions influenced by common shortfalls in thinking?
When it comes to investing, people tend to make suboptimal decisions that are based on emotions, rather than logic. Inexperienced investors may unknowingly end up buying high and selling low, underestimating investment risks, or move funds from high to low-risk securities based on their gut, when the market is volatile.
Without sound professional advice, some investors tend to go with guesswork. Because of this, they are unable to ascertain or identify value in returns, and they end up having much lower risk tolerance, which in the long-term can hinder their life’s financial plan.
Common behavioural biases that sabotage good decision-making can sound a lot like these:
No one is immune to great and terrible loss. We all know that, yet sometimes we forget that bad things can happen to us, if we are not careful and if we don’t plan ahead in a comprehensive manner. It’s called Optimism Bias and it can lead us to think that bad financial decisions are only made by other people, not us. This can lead us to underprepare for negative outcomes or overcommit to something we expect to be positive.
Remedy:
It is good to put ourselves in the shoes of others in unpleasant situations every now and then. Especially situations that we imagine will never happen to us. By doing so, not only will we start to assess whether we are prepared to overcome certain challenges, we will also become more compassionate and less judgemental towards others. Everything comes with a balance. It is also not healthy to have a victim mindset, with a Pessimism Bias that makes us always expect the worst outcomes or negative results.
If we focus too much on immediate or shorter-term plans in the way we invest our resources, we may miss out on some bigger things that are equally important which may not necessarily be within our sight yet. One classic example of Present Bias2 is that most people forget to plan for their retirement until it is a little too late, committing their wealth instead to cars, luxury goods or big vacations.
Remedy:
By factoring in short- as well as long-term strategies in our plans, we make better investment decisions for today and for tomorrow. Start by looking at your milestone goals throughout your life stages. Make sure those are taken care of as you enjoy the fruits of your hard work today.
We know there are important matters to attend to on the horizon but we put them off, telling ourselves everything is alright. We act at the speed of thought and are highly productive individuals who shine in any stressful situation of intense complexities. But like the frog in the boiling pot, we succumb to Status Quo Bias which makes us feel so cosy where we are that we fail to act. Sooner or later, that important thing on the distant horizon becomes an urgent thing, and then an emergency situation that can no longer be ignored.
Remedy:
Review your financial plans regularly and make sure they are in line with the way your life is moving. Make it a habit to do the tough stuff, and check off those annoying but necessary actions that you’ve been putting off. Tick off your to-do list with an experienced financial consultant for a peace of mind that money cannot buy.
Our money is hard earned therefore loss is always a painful thing to take. This might motivate some to shun taking any options that might lead to a higher risk of loss. Because of Loss Aversion Bias, they stick to safe options like Fixed Deposits which might not even outgrow inflation, putting their wealth goals at risk.
Remedy:
Losses should be seen not always as a bad thing. They offer us learning points and a view of our blind spots. They give us an opportunity to gain knowledge so that we do not repeat our mistakes. Give yourself and your money a chance to grow by exploring other tried and tested options which, though unfamiliar to you, might give you opportunities for good returns too.
Familiarity is a dangerous place. It can lull us into oblivion. In our constantly changing world, one may be on top today but that spot is not guaranteed tomorrow. People who make decisions on Familiarity Bias3 stick to what they know. For example, they might invest only in local stocks or the brands and companies they are familiar with rather than explore a more diversified or even a global portfolio.
Remedy:
Open yourself to other tried and true possibilities. Learn something new every day that will take you closer to better and more efficient ways of reaching your financial goals and life aspirations.
Have you ever hung on to losing stocks longer than it is good for you, or have you ever made a hasty sell on a fast-rising stock only to discover you should have held on a little longer? Your decision could have been due to your Disposition Effect Bias4. Favouring an easy win or putting off a certain loss are two ways that we can trick ourselves into making a poor decision because as humans, we are wired to love winning and hate losing. It is that same fallacy in thinking that makes us very capable of convincing ourselves that two gains are better than one loss, even when the value of the one loss outweighs that of the two gains.
Remedy:
Educate and inform yourself on your decisions based on rationale thought and sound advice. Use intellect rather than emotions to take your steps.
When it comes to investing, it is better to arrive at financial strategies based on knowledge and experience, to avoid succumbing to thinking without really thinking. By developing far-sightedness and having a higher risk tolerance in the long run, you will be better prepared in an unpredictable financial situation.
As it is, the human race has gone through two unprecedented years of the COVID-19 pandemic, as well as numerous other financial crisis in the past. Challenges are always there.
If you find that the same consequences or negative outcomes keep happening to you, it may be a good idea to take a long and deep reflection on your financial decisions-making habits.
Have any cognitive biases led you to focus on wrong information, or overlook facts? Alas, we’re only human. While we can’t exactly eliminate these biases or change our thinking overnight, we can decrease our vulnerability to them. Get better at planning your finances and investment dollar by understanding how automatic thought patterns should be replaced by unbiased decision-making. Learn, question, and collaborate to gather expertise when it comes to your investment portfolio. Life is about constantly making yourself more adaptable to new situations.
If you would like to explore better financial decision-making for your life’s journey, give me a call and let’s have coffee.
1Source: https://www.researchgate.net/publication/316486755_Cognitive_Biases_that_Interfere_with_Critical_Thinking_and_Scientific_Reasoning_A_Course_Module
2Source: https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/present-bias/
3Source: https://www.igi-global.com/dictionary/familiarity-bias/47387
4Source: https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/disposition-effect/
