Every day our experiences and views influence the decisions we make. It’s no different for financial ones. Whether consciously or not, bias can have an impact on your financial future. Understanding financial planning behaviours can lead to decisions that use logic rather than emotion.
What is financial bias?
Bias is something that affects your decision other than facts. This could be gossip you’ve heard from friends or the impact of previous experiences. From an evolutionary point of view, this is a good thing. Using a variety of reference points allows for quick analysis and decision making.
However, this may not translate well in financial decisions. It can be easy for negative financial planning behaviours to have an impact. The first step to reducing this is to understand what behaviours to look out for. There are many ways that bias can affect financial decisions, here we take a look at five common ones:
1. Confirmation bias
We often seek out like-minded people. And this can be the case when searching for information too.
Confirmation bias refers to a financial planning behaviour to seek information that confirms existing opinions. It also means you’re more likely to disregard those that refute your opinion. As a result, you’re selecting the information you place weight on. Assessing information is important but you should also consider the facts.
An example would be when you’re researching potential investments that you believe will outperform the market. Confirmation bias may mean you dismiss credible sources of information. It could lead to you taking greater risk than appropriate.
Similarly, investors often base their decisions on the first source of information to which they are exposed, such as the initial purchase price of a share. They then have difficulty adjusting their views to new information.
2. Loss aversion
Would you rather not lose £50 or find £50?
Loss aversion refers to a tendency to prefer avoiding losses to acquiring gains. Some studies suggest the emotional pain of losing money is more powerful than the satisfaction of gains. As a result, bias may mean you avoid situations where you could lose money or make poor decisions if there’s risk involved.
This theory explains why investors hold onto losing shares: people often take more risks to avoid losses than to realise gains. This means that investors often willingly remain in a risky position, hoping a share price will recover. It’s much the same way that a roulette player will double up bets in a bid to recoup money they have already lost.
3. Mental accounting
Separating money can help you better manage your finances. Perhaps you have a savings account for holidays, for example. This isn’t always a bad thing. But it may mean your money isn’t working as hard as it could be.
Let’s say you have a savings account for that future holiday you’ve been looking forward to. Each month you place a set amount in there, but you also have credit card debt. In some cases, it’d be more efficient to pay off debts first. This is because it’s likely interest on the debt is higher than the interest paid on savings. This financial planning behaviour means you’re reviewing in isolation. Instead, you also need to consider the bigger picture to get the most out of your money.
4. Paralysis by analysis
There’s an abundance of financial information available. Whether you’re deciding how to access a pension or where to save for a grandchild’s future, it can be overwhelming. With so much ‘noise’, you may not know what to do.
Paralysis by analysis is a financial planning behaviour that describes this. If you’ve ever decided not to act because deciding was difficult, it could have affected your future. Filtering through balanced information and understanding the impact can be challenging. However, it’s an important step to overcome paralysis by analysis; financial planning can help.
5. Money illusion
How much income will you need each year in retirement? Your answer is likely based on the cost of living today. Yet, inflation means that income won’t go as far in 20 years’ time.
Money illusion may mean you opt for safer financial returns. For example, putting savings into an account that delivers 1% interest. At first glance, this may look like your savings are growing. But once you consider inflation, the savings will be decreasing in real terms.
Money illusion is also cited as a reason why low inflation (1% to 2% per year) is desirable. Low inflation allows employers, for example, to modestly raise wages in nominal terms without paying more in real terms. It means that many people who receive a pay rise believe that their wealth is increasing, regardless of the actual rate of inflation.
This financial behaviour can also lead to people overestimating values in the future. It has a bigger impact on long-term financial decisions, such as pensions.
How does financial planning help?
The above and other financial planning behaviours are often done subconsciously. So, what can you do?
Financial planning can offer a way to reduce bias affecting your decisions. It offers a chance to look at your financial situation from another perspective. This can be a useful way to filter out potentially harmful behaviour. Creating a long-term plan and undertaking regular reviews is also valuable. It’s a process that can help prevent you from selling stocks too early, for example, if loss aversion is something that’s had an effect in the past.
If you’d like to discuss how you make financial decisions, please contact us.
Please note: The value of your investment 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.