Here we discuss psychological biases that often prevent us from making logical financial decisions:
Anchoring – The tendency to rely too heavily on the first piece of information we receive when making decisions. By doing so, we discount information more beneficial to our decision process.
Availability Heuristic – The tendency to overestimate the likelihood of events based on the vividness or recency of the memory. This makes us fear the likelihood of financial crises when, in fact, they are relatively rare.
Bandwagon Effect – The tendency to do or believe things because many other people do or believe the same. See also groupthink and herd mentality. It’s easier to think we’re making the right decisions when other people are doing the same. However, others, like you, often make bad financial decisions.
Buyer’s Remorse – The sense of regret after having made a purchase. Particularly pertinent if the result of a difficult decision or large investment. Overseas property investment is a classic case.
Confirmation Bias – The tendency to search for, focus on and remember information in a way that confirms our preconceptions. We may seek an adviser who tells us what we want to hear.
Conjunction Fallacy – The tendency to assume that specific conditions are more probable than general ones. Generally, investment returns are positive, yet our initial assumption is that we will lose money by investing.
Declinism – The predisposition to view the past favourably compared to perception of the future. This is why people continue to stick to what they’ve always known, rather than making necessary changes for the better.
Decision Fatigue – The deteriorating quality of decisions made by an individual after a long session of decision making. Making too many choices is exponentially aversive to good outcomes. This can also lead to ‘Decision Avoidance’, where we choose to make no decisions simply because we are unable to narrow down the options presented to us.
Ego Depletion – The belief that self-control or willpower draw upon limited resources of mental strength. We make bad choices almost as a reward for long-periods of making good choices. Think of a smoker who is trying to quit, rewarding themselves with a cigarette for making it past week 2.
Empathy Gap – The tendency to underestimate the influence or strength of feelings or emotions when it comes to making decisions. We fail to realise how much of our decision process is guided by emotion.
Endowment Effect – The tendency for people to demand much more to give up an object than they would be willing to pay to acquire it. People place a higher value on things due to the simple fact that they own them. Examples would be selling a house or car. The same is true in reverse – this is why we clean our homes ourselves rather than paying a cleaner to do it, yet we wouldn’t clean someone else’s home if they paid us the same amount.
Exaggerated Expectation – Real-world evidence turns out to be less extreme than our expectations. This may result in disappointment in what is, in isolation, a favourable outcome. Think of a year in which your investment portfolio returns 6%, after it had yielded returns of 11% the year before.
Fundamental Attribution Error – The tendency to blame others when things go wrong, rather than looking at a situation objectively. You may make a bad investment decision, and blame the friend who told you about it, when it was ultimately your decision to make.
Gambler’s Fallacy – The tendency to think that future possibilities are altered by past events when, in reality, they are unchanged. Think of flipping a coin which has landed on heads 5 times in a row – we’ll overestimate the probability of the sixth flip being tails. The longer things go well, the more we fear something bad happening in the future.
IKEA Effect – The tendency for people to place a disproportionately high value on something they’ve assembled themselves (think flatpack furniture) despite the ultimate quality of the end result. For example, in a period when equity markets have performed well, anyone who’s done a bit of research and picked some funds will overestimate their skill when these funds subsequently provide decent returns (in isolation).
Loss Aversion – The pain we feel following losses outweighs the joy we feel following equivalent gains by 2:1. Imagine losing £50,000 compared to gaining £50,000, following a £100,000 investment. The money has moved by the same amount, yet the loss has a far greater impact on our emotion.
Money Illusion – The tendency to concentrate on the face value of money rather than its real value in terms of purchasing power. This is magnified as the numbers get bigger. We are able to appreciate that £20 won’t buy as much in the future as it does today, yet we struggle to equate this to larger sums. Convert this to £200,000 – the impact of inflation is still relative, yet we fail to pay it the same credence.
Negativity Bias – Humans have a tendency to better recall negative or unpleasant memories compared to positive memories. This, in turn, impacts our future decision making as we immediately turn to bad experiences in the past for confirmation.
Normalcy Bias – The refusal to plan for something simply because we haven’t experienced it before. Think about retirement. You won’t know how it feels to retire until you actually do it. Wouldn’t it be nice to have planned for it anyway?
Omission Bias – The tendency to judge harmful actions as worse than equally harmful inactions.
Optimism Bias – The tendency to overestimate the likelihood of favourable or pleasing outcomes based on a decision. This is why millions of people play the lottery but neglect their savings.
Overconfidence Bias – Excessive confidence in one’s own ability. This is why we trust ourselves over impartial professionals when it comes to making financial decisions.
Paralysis by Analysis – over-analysing a situation to the extent that a decision is never actually taken, effectively paralysing our ability to actually reach a conclusion. When presented with too many options, we simply lose the ability to function rationally.
Post-Purchase Rationalisation – The tendency to convince yourself through rational argument that a purchase was good value.
Projection Bias – The tendency to overestimate how much our future selves will share our current views, values, opinions and preferences. You may continue working towards a goal that has since become unimportant.
Regret Aversion – The tendency to avoid making decisions through fear of regret.
Restraint Bias – Overestimating our ability to show restraint in the face of temptation. Thinking we have a grip on credit card debt (nobody does).
Risk Compensation – The propensity to increase risks when perceived safety increases. We may take greater risk with our pension pot if we have other guaranteed retirement income, only to be devastated when our fund value dramatically declines.
Status Quo Bias – Preferring things to stay the same, regardless of potentially better options.
Sunk Cost Fallacy – Justifying increased belief in a decision based on previous decisions, despite new evidence suggesting the decision was probably wrong. The more you invest, the harder it becomes to let go.