Published on: 30th June 2020
When we think of bias, it probably isn’t financial decisions that come to mind first. However, bias can mean we don’t focus on the facts and logic when making decisions. It often happens without us realising it and, at some point, financial bias has likely affected you.
Financial decisions should be focused on the fact, but bias means emotions, prejudices and previous experiences can cloud our judgement. Bias can affect decisions in multiple ways, but a recent High Court case has highlighted just how much we can let emotions get in the way of sound logic.
After nearly 22 years of marriage, a husband and wife decided to divorce, having to split their assets too. It’s something that happens every day in the UK and we all know that it can be an emotional and turbulent time fraught with tension. However, where this case differs is that after numerous oral hearings, applications and trials, combined legal costs have wiped out all assets. Having incurred nearly £600,000 of combined costs, the couple has ended up with about £5,000 each in liquid assets.
At the time of the case, we’re sure both parties believed they were acting in their best interest. But with hindsight, it’s left them both with far less than it could have.
This is a dramatic example of emotion affecting financial decisions and there are other ways it can have an impact, including on investment decisions. Here are five types of financial bias you may recognise as part of your behaviour.
We’ve all heard of jumping on the bandwagon and following trends. In investment terms, you’ve probably been told by someone that ‘everyone is investing here’ or that ‘you should divest from this sector’. If someone you trust or a news source is saying this, it can be easy to follow the masses and make financial decisions based on this.
However, you need to keep in mind that your goals and risk profile can be wildly different from someone else’s. A group of people investing for retirement 30 years away are unlikely to have the same investment strategy as someone saving for their child’s education in just five years. Keep in mind your circumstances and aspirations should always be the centre of goals.
2. Confirmation bias
First impressions often matter, but we can place too much weight on them.
In the case of confirmation bias, we seek information and data to support our preconceived ideas. With such a wealth of sources at our fingertips, it’s not something that’s hard to do today. But it does mean we end up dismissing those sources that go against what we’ve already decided. As an investor, it’s important to look at sources of information from a balanced point of view, weighing up their worth and value based on the data rather than what you want to believe.
3. Disposition effect bias
Disposition effect bias refers to the tendency to label investors as ‘winners’ or ‘losers’. It’s easy to see where this bias stems from. A quick look at the financial headlines and you’ll often find investments, funds and other assets labelled in this way. It’s eye-catching and snappy, but it doesn’t give you the full picture.
By thinking of investments in terms of ‘winners’ and ‘losers’ you can end up selling or buying at points that don’t align with your financial plan. It’s far more important to look at your long-term plan and goals than those investments that are deemed ‘winners’ this week.
4. Loss aversion
How much risk do you take with your savings? If you prefer not to take risk or feel uncomfortable about investment risk, loss aversion could be having an impact. It’s a term that refers to a mindset that it’s better to not lose £100 than to gain £100. In an investment setting, it may mean that you’re being too cautious and potentially missing opportunities.
It can be difficult to remove worries about investment risk when making decisions. Here, a financial plan can help put into perspective risks and what it means for your wealth.
5. Anchoring bias
Finally, anchoring bias is where we place too much importance on one particular source of information or past reference when making decisions. The obvious example here is share price. If you’ve ever kept hold of an investment when you perhaps shouldn’t because of a previous share price, anchoring bias may have played a role.
We know that share prices change and how many times have you read that ‘past performance is not a reliable indicator of future performance’? But it’s still easy to anchor the value we give investments to a single piece of information. Keeping an open mind and looking at the bigger picture is important here.
How does financial planning help?
Financial planning doesn’t just help you set out a long-term plan, it can also highlight where financial bias is occurring. By having another person’s perspective, it can indicate where bias may be affecting you. If you’d like to discuss your financial plan and the decisions you make with a professional financial adviser, 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.