In these uncertain times of war and pandemics, it’s easy to react to world events in emotional ways. In fact, there are several common behavioural biases that could be leading you to make knee-jerk or spontaneous financial decisions that could damage your long-term prospects.
But what exactly are these behavioural biases? And what sort of impact can they have on your personal finances? This article will tell you everything you need to know about these biases, and some ways you can avoid them.
1. Loss aversion
Simply put, loss aversion is when people favour avoiding loss over making gains.
The theory of loss aversion suggests that losing £100 is twice as emotionally impactful as gaining £100. The sting of loss is greater than the pleasure of gains, which could in turn cause people to be too risk-averse when it comes to their money.
In investing terms, loss aversion may mean you completely avoid risk in fear of “losing” some money, or not selling shares when they’re performing poorly in the hope of recovering from the loss.
Loss aversion can lead to low-risk investment strategies that could hamper your progress towards your goals. You could, for example, decide to invest in “safe” securities that offer lower potential returns, but are less volatile. While you may potentially avoid some risk, it may mean that your pension fund doesn’t grow as much as it needs to for you to achieve the lifestyle you want in later life.
2. The Semmelweis Reflex
The Semmelweis Reflex is a behavioural bias that causes people to reject new evidence or information that contradicts already pre-established facts. This knee-jerk behaviour, or reflex, borrows its name from the eponymous Hungarian obstetrician from the 19th century.
Semmelweis found that the fever that was common among new mothers in hospitals could be all but eliminated if doctors washed their hands. This came at a time when doctors would frequently perform surgery in the morning, and then deliver a child later that day, all without washing their hands.
Expecting his new discovery to make revolutionary ripples in the medical field, you can imagine his surprise when his ideas were rejected and he was disgraced, even though his theories were easily proved. In fact, his ideas were only accepted 14 years later, and he was honoured posthumously.
The tragic tale of Semmelweis is often reflected by investors making financial decisions, too. For example, some investors may blindly follow pre-established financial norms, rather than taking on new information that could help them better decide how to invest their money.
Instead of relying on your own personal beliefs or any ideologies you may hold, you should instead aim to review evidence from many different sources – for example, by taking advice from a financial planner.
3. Confirmation bias
Confirmation bias is a relatively common behaviour in many walks of life, not just finance.
It occurs when people make decisions based on pre-established assumptions built on emotion rather than fact. This, in turn, means these decisions tend to be based on inaccurate information.
A good way to think about confirmation bias is with a newspaper. Usually, people will buy a publication that best represents their political stance, and they tend to specifically look for information, sometimes even subconsciously, that confirms their beliefs.
In terms of finance, confirmation bias can have detrimental effects on the decisions you make. If you have an established belief that a specific sector or company will perform well (or poorly), even if evidence suggests otherwise, you could end up with a portfolio that isn’t sufficiently diversified.
4. Anchoring bias
As the name probably suggests, anchoring bias is when you put too much emphasis on a single piece of information over all others and then “anchor” your entire set of views to it.
For example, you might see a TV advert for a sofa that was £999 but is now £399. It seems like a genuine bargain, and it might be, but anchoring affects your judgement.
You might decide that something is a good deal simply based on a reduced price point (the anchor), without considering whether you’re still getting value for money.
Financially speaking, anchoring bias is potentially damaging as it could stop you from selling a share or other asset when you should. This is due to the fact that you’re fixed on your anchored information and think the share or asset is more valuable than it really is.
As is the case with the Semmelweis Reflex, you should ideally aim to be open to new sources of information and be critical of the information you’re already receiving.
5. Familiarity bias
When you’re investing, diversification is vital if you want to mitigate risk. So, while it is good to invest in the areas you’re knowledgeable in, you still need to spread your investments accordingly and not just invest in what you know. This will help you to avoid familiarity bias.
A good example of this is that the UK stock market only represents around 4% of the overall value of global equity markets. If you were to hold more than 4% of your wealth in UK-based shares, you’re displaying familiarity bias since you are investing in “what you know”.
Get in touch
One of the benefits of working with a financial planner is that we can act as a sounding board and a mentor when it comes to making financial decisions.
We can help you avoid emotional choices that could severely damage your long-term financial goals. So, if you would like to chat, email email@example.com or call 01313 786680.
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.