June 19, 2020

Cognitive Biases – 5 Common Biases That Affect Our Decisions

by eswalton in Financial Planning

This blog looks at 5 common behavioral problems most investors face. Having a good investment experience is often a result of the actions of each investor. The most successful investors can ‘behave’ well and stay disciplined over the long term, particularly in times of uncertainty. Having the ability to stay focused and disciplined with our investment approach has never been more important, as we currently face one of the most uncertain economic periods in modern history, as a result of recent events.

To start with, let us get a better understanding of cognitive biases and how they drive our behavior in the first place.

What is a Cognitive Bias?

A cognitive bias or ‘heuristic’ is a collection of systematic errors in thinking that occur when we are processing information. Studies have shown that our senses send 11 million pieces of information to our brains every second. Our conscious mind however can only process 50 pieces of information per second. Therefore, we need a mechanism to compress the information and focus on what is important.

A cognitive bias is the brain’s attempt to shortcut complex decisions into simple rules. They are our brain’s way of processing complex sources of information and making decisions quickly. We are constantly making micro-decisions throughout the day and to avoid decision fatigue, our biases help us make quick, automatic decisions. We are constantly being led by our in-built heuristics and although they can be helpful, when it comes to making logical and objective decisions, they can trip us up with the default auto-response. No more so, than when it comes to making emotional decisions regarding money.

Where do they come from?

Biases are often a result of memories. Our memories and past experiences often dictate to us how we should make decisions in the present. This may be based on a poor or favorable outcome from a decision made in similar circumstances in the past. From a financial perspective, this goes back as far as you can remember from your first experience with money or how finances affected your life as a child. We all form our own biases based on experiences and explains why when presented with the same information, we experience different outcomes.

We also suffer from information overload. Since we know our brains can only process a limited amount of information it is presented with, it needs a quick way to process what is important. In other words, what we should be paying attention to.

Over time we all develop our own cognitive biases as our way to filter out unnecessary information and make quick decisions. They subtly creep into our lives over time as we make more decisions and achieve a positive or negative outcome. Eventually, we can become unable to make truly objective decisions. Some of the examples in this blog can be easy to spot in others but recognizing our own biases is practically impossible.

How we really make decisions

We all like to think when faced with a decision we are logical, objective, and fair. We believe that we evaluate the information presented and make a decision accordingly. Unfortunately, our biases can often shortcut this process for us, cutting out information considered ‘not important’ to lead us to a decision quickly and efficiently. We don’t know this is happening and often we believe that our instinctive thought process is correct. Taking this approach with your finances is dangerous and can often lead to poor reactionary decisions and outcomes.

When we experience a poor outcome, we tend to look at external sources as the reason why this may have occurred and try to logically explain the result. The simple answer may be that our heuristics have ‘helped’ decide for us, having a bigger influence than we realized at the time.

Financial decision making

Let us now put this in the context of our finances. None of us are truly logical when it comes to money. It is a subject that can spark emotions like greed, fear, shame, guilt, and envy. These are powerful influencers on our decision-making ability and can lead to supercharged cognitive biases. It’s important to recognize when we are making the logical decision and when we are being shortcut to a default decision. It’s harder than you might think, let’s look at some examples.

1. Confirmation Bias

Confirmation Bias is the tendency to seek out information that confirms our opinions and beliefs as being correct and refute any information to the contrary. Moreover, when it comes to making decisions, to avoid regret we tend to align with a social group that has similar views as our own. We like to surround ourselves with people who tell us what we want to know and not what we need to hear. Further fuelling our own bias.

Investors will tend to seek out the research or ‘investment experts’ that support their investment philosophy instead of looking to find reasons why they might be wrong. The additional confirmation can lead to overconfidence bias. This can in turn lead to the feeling that nothing can ever go wrong.

Tip – research alternatives options before making big decisions. Don’t jump straight into big financial decisions as you might not have the whole picture. Take your time to assess the options and ask others who may not align with your thinking to give you their opinion.

2. Bandwagon Effect

The Bandwagon Effect, sometimes referred to as ‘group think’ is the tendency to follow the actions or behaviors of a group regardless of our own beliefs and values.

It’s common for people to make a choice based on a comparison with an anchor or accepted behavior by a group, even if it’s completely irrelevant. If you measure your results using this anchor, you could find yourself becoming a victim of the Bandwagon Effect.

As an investor, if your returns are less in comparison to the returns of the crowd (your anchor), this can lead to disappointment and a feeling of missing out. To eliminate this ‘risk’ it feels safer to simply align with the crowd and invest in the same way. Risk and return are closely linked, and the higher return experienced by the crowd is likely due to the higher risk than is appropriate for you.

Most stock market bubbles are the result of the Bandwagon Effect. The dotcom bubble in the 1990s and the financial crisis of 2008 are both recent practical examples. It is easy to get carried away with the hype, particularly when prices are rising sharply and everyone else seems to be making money.

Tip – A successful investor must be able to remove this bias from their investment decision-making process. Employ third party, independent consultants to help you make truly objective and logical decisions when it comes to building a portfolio. All bubbles eventually must burst!

3. Loss Aversion

Loss Aversion suggests that the pain experienced in losing is significantly more powerful than the pleasure of making an equal gain.

It is often believed that the pain of losing 10% on an investment portfolio can feel twice as bad as the 10% gain felt good. We all act differently to positive or negative changes to their status-quo and this then flavors our comfort level regarding our investment decisions.

Insurance companies often use this bias to their advantage in their marketing efforts. They will list the unlikely but costly outcomes we may encounter if we do not have insurance in place to cover the loss. This desire to avoid the potential large losses primes us to forget about the small regular monthly premiums for the policy over the next 30 years.

Those who suffer from Loss Aversion tend to consider themselves cautious and not willing to experience short term fluctuations or expose themselves to potential larger losses. They will tend to weight potential costs and failures much heavier than the potential benefits and rewards.

With investing, people will opt for a low volatile portfolio as the experience of seeing the portfolio ‘lose’ money, however temporarily on paper, is too much for them to handle. This low growth portfolio could result in them running out of money prematurely, due to their attempt to avoid the feeling of loss in pursuit of a sustainable growth rate.

4. Endowment Effect

The Endowment Effect refers to the tendency to value an item that we own more highly than its true market value.
Often seen with items that have an emotional or symbolic significance to us, the endowment effect can skew our perception of the true value.

In a study by psychologists Kahneman, Knetsch, and Thaler, respondents were asked to value a mug and a bar of chocolate separately. The chocolate was given the higher value by the respondents, however, 89% of those endowed with the mug at the start of the class refused to trade It for the chocolate. On the flip side, when the chocolate bars were given first only 10% then chose the mug. This famous example shows how we weight the value of an item in our possession greater than when we value it objectively.

When it comes to investing, we are vulnerable to becoming particularly attached to holdings within our portfolios or a particular fund manager or provider. If we stepped back and started again with this portfolio, these holdings would not necessarily be the ones we would choose. So why hold onto them?

Tip – If you are holding onto a legacy portfolio due to an emotional connection with the source of the funds, the provider, the performance, etc, it may be worth taking a step back and considering the true value of this investment in helping you achieve your financial objectives. Ask your adviser to help and provide you with an objective analysis of the plan.

5. Anchoring Bias

This is the tendency to make decisions based on the original piece of information available (the anchor).
Once an anchor is set, it’s very difficult to ignore this as a reference point for making decisions. Price positioning is often used by retailers to help us feel like we are getting a good deal. During a sale, the original price remains visible on the item, typically just above the now discounted price. The feeling that we will be saving the difference between the two prices for a limited time, helps flavor our decision to buy. The anchor of the original price is the key to this decision, even if this was never the true price in the first place.

When making investment decisions we will typically anchor our perception of value to recent sold prices of property or stocks when deciding to buy. Investors will anchor the value estimate to the original price as opposed to the objective fundamental value, often leading to a poor decision.

When it comes to making decisions, we are sometimes hamstrung by our cognitive biases. The examples listed here are just a few that can affect our decision-making abilities and lead us to make ill-informed decisions. When it comes to financial decision making, we are further hampered by our emotional connection to money and past life experiences. This is one of the major reasons we believe that behavioral financial planning is of significant long-term value to our clients as we help navigate many of these choices and decisions throughout life.

We will have more to come on cognitive biases; what to look for and what you can do avoid falling victim to them in future blogs.
If you would like to talk to one of our financial planners about Cognitive Biases or for any further information, please feel free to contact us.