Understanding financial bias: Where does it come from?
Posted onLast month, we looked at what financial bias is, but what is it that influences our decisions? Where do these biases come from?
There are numerous ways bias can affect the financial decisions we need to make and can mean we’re not focusing on logic. We’re all prone to letting biases creep in at certain points, understanding what it is and what may be having an influence is the first step to basing decisions on facts.
Often, biases can be split into four distinct categories:
1. Self-deception
First, is the concept of self-deception, the belief that we know more than we actually do.
This self-belief means we may not seek out or miss information that can help us make an informed choice. In a fast-paced environment, where information can change rapidly, it’s important that accurate and up-to-date information is used to support decisions. Failing to find more information can lead to you holding on to outdated data or even information that provides only a single snapshot, rather than the whole picture you need for it to be effective.
In terms of finance, self-deception could mean not seeking out professional help that you could benefit from it or failing to conduct balanced research when exploring investment options.
Challenging what you know and the existing beliefs you may hold can help reduce bias. One of the barriers to this is the sheer amount of information available. Filtering through the ‘good’ and the ‘bad’ to understand what’s important can be difficult and time-consuming.
2. Heuristic simplification
We’ve all made mistakes when processing information, and this is what heuristic simplification covers.
We’ve evolved to make quick decisions without having to stop and constantly think about what our next course of action should be. A shorter decision-making process can be useful in many situations, but it can also mean certain assumptions need to be made and information is misinterpreted. Linking back to the above point, with more information at our fingertips, making speedy decisions can mean even more data is missed.
Heuristics aren’t a bad thing, imagine how long it would take to get anything done if you deliberated every possibility of the thousands of decisions you make every day. Recognising where you should take a step back and spend time focusing on exploring different options is important to make sure you don’t overlook relevant information.
3. Emotion
Again, we’ve all made emotional decisions in the past. How we’re feeling at the time of making a decision can influence what we decide. As before, this can be useful in many situations but when it comes to finances, a rational, clear-minded approach can help keep you on track.
Stock market movements are a good example of how emotions can affect even the best-laid plans. When stock markets fall, reducing the value of your investments, you may be worried or fearful. These emotions can tell us that our future is at risk and that we should take steps to protect it, such as taking funds out of investments to limit losses. But start with a rational view, and often it’s the case that short-term volatility has been experienced. When you look at the historic movement of stock markets, a downturn has been followed by a recovery. Cutting emotions out of the process can help you see this and what is best for your long-term plans.
4. Social influence
Finally, others can affect our decisions too. This may be family and friends giving their opinion on how you should invest, where to save or your pension, for example. But other sources can have a social influence too. This may include newspapers and online sources. If you read a headline declaring the ‘best funds’ to invest in, it’s not surprising that you’re tempted to follow suit.
The key thing to remember here is there is no one-size-fits-all solution for everyone. A financial decision that makes sense to a family member, or even several people you know, doesn’t mean it’s right for you. Focusing on your circumstances and goals can help minimise the impact of social influence on financial decisions.
Next month, we’ll explore some of the most common biases that could be affecting your decisions. You may recognise some of your own behaviour in them, but it can help you remove bias from your financial decisions.
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