From the moment you wake up in the morning until your eyes close at night, your life is a series of decisions. Indeed, University of Leicester research published by CNN suggests that your brain makes upwards of 35,000 decisions every single day. Assuming you sleep for eight hours, that’s 36 decisions every minute of your life.
Of course, we’d all like to think that we always make perfectly rational decisions, weighing up the various options and acting in our best interests. In truth, however, this is often not the case.
Indeed, the Nobel laureate Herbert Simon argues that knowledge of all alternatives, or all consequences that follow from each alternative, is realistically impossible for most decisions that humans make.
Many of your decisions will be led by other factors – perhaps the environment you are in, the speed at which you have to make a choice or, more commonly, by your emotions.
When it comes to financial decisions, it’s easy for emotions to take over. Indeed, a recent survey published by FTAdviser found that 63% of surveyed financial advisers said they are “frequently” or “regularly” surprised by the decisions or proposals their clients make about investments.
And, this approach can be costly, with advisers believing that investors’ emotional decision-making is costing them at least 2% each year in foregone returns.
So, if you want to take control and ensure you’re not making decisions that could hinder your progress towards your financial goals, here are four common cognitive biases to look out for.
1. Confirmation bias
Coined by the English psychologist Peter Wason, confirmation bias is the tendency to favour information that confirms or strengthens your beliefs or values. It can be difficult to dislodge once affirmed.
As Leo Tolstoy wrote: “The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.”
The FTAdviser study found that, when asked what they thought was the biggest mistake their clients made in their investment decisions, financial advisers cited “being too influenced by the news”.
This is likely to be confirmation bias in action. If you seek out news that aligns with your pre-existing beliefs – you likely prefer news sites that share your political views or ethics – then the information you read may simply confirm pre-conceived ideas that you have.
You might decide to cash in investments in volatile times because you read an opinion piece suggesting the same while ignoring contrasting opinions that provide an opposing point of view.
2. Loss aversion
The theory of loss aversion suggests that humans feel the pain of losses twice as strongly as the pleasure of gains.
The second biggest mistake financial advisers say their clients are making is “taking too little risk” – and this is likely to be linked to loss aversion.
If you’re worried about losses, you’re liable to take too little risk with your money, perhaps preferring “safe” options such as cash savings. Any downturn in the markets will be magnified – you’ll worry about potential losses but not have the same positive reaction when things are going well.
Taking too little risk means you may not generate the level of return you need in order to achieve some of your longer-term goals, such as early retirement or a comfortable standard of living.
For example, you recently read about why cash savings might be more risky than you think, as your wealth could be shrinking in value in real terms.
3. Overconfidence bias
According to research published by the Open University, 80% of drivers think they are “better than average”.
Of course, mathematically this can’t be the case! It’s an example of “overconfidence bias”, namely the tendency for an individual to overestimate their ability.
If you pick the right investment a couple of times, you could easily end up thinking you’re a more skilled investor than you really are. This can then lead to you making increasingly risky investments, potentially leading to losses larger than you can tolerate.
The truth is that it’s almost impossible to consistently “beat the market” – even well-paid and experienced fund managers don’t get it right all the time. Instead, a well-diversified portfolio aligned with your tolerance for risk, held for the long term, could be a better path to achieving the returns you need to meet your goals.
4. Herd mentality, or FOMO
Have you ever seen a large group of people walking down the street and considered joining them as you’re intrigued by what is going on? Or watched the latest TV drama because your colleagues told you it was great?
If so, you’ve exhibited “herd mentality”, sometimes called “fear of missing out” or FOMO.
Humans tend to follow and copy what others are doing, and this often occurs in the investment world. If you hear about a “surefire winner”, or that a few people you know have invested in a certain company or fund, you may think that you need to do the same.
However, these decisions are largely influenced by emotion and instinct, rather than by your own independent analysis.
Many investors in the US business GameStop found this out the hard way.
Back in 2020, a well-organised online group started buying shares in the struggling retailer, sending the price soaring and forcing institutional investors who bet against the company to back out. Between 8 December 2020 and 27 January 2021, the share price rose from $13.66 to more than $354.
Those who joined the “herd” later on and bought shares at inflated values would then have likely seen losses. As of 13 July 2023, the GameStop share price is just $23.66.
Simply following what others are doing is, in many ways, the opposite of our approach to financial planning. Your plan should focus on your own unique goals, with a portfolio constructed around what you want to achieve – not what everyone else is doing.
Get in touch
Working with a financial planner can help you to avoid some of these common cognitive biases. We can act as a sounding board, helping you to avoid knee-jerk decisions that could prove costly.
To find out more, please get in touch. Email hello@sovereign-ifa.co.uk or call us on 01454 416653.
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.
