How to Make Good (Financial) Decisions: A Biased Story
Everyday we make thousands of decisions, some of which are instinctive and others are more complex. We like to think we are good at making complex decisions, but the reality is we are often led by cognitive and emotional biases. We introduce the different biases that influence our decision making, so that we can be more aware of them and (hopefully) make better informed decisions, especially financial ones.
Every day we make thousands of decisions, ranging from the very simple, such as deciding to put left or right foot forward when beginning to walk, to the very complicated, such as deciding what to watch on TV from the plethora of shows available. Most of these decisions are instinctive or even done subconsciously.These decisions are principally controlled by the amygdala part of the brain, also referred to as ‘lizard brain’. These decisions are usually made incredibly effectively and speedily as they originate from our natural instinct to survive, eg, to remove your hand from a hot stove.
When it comes to more complex decisions, these are controlled by the prefrontal cortex part of the brain (‘The Smart Brain’). We like to think we are good at making complex decisions, but the reality is that we often are very poor and inefficient at making these decisions, particularly in comparison to decisions made by the lizard brain. I know I have spent an eternity scrolling through Netflix to find a film and then regretted my choice 5 minutes after the opening credits! Imagine if the consequences if the lizard brain took that long with the hot stove. In addition, often the more complex or important the decision the poorer we tend to be in making the decision. So, how do we become better at making these complex decisions? The first step is to understand what influences our decision making and why this can lead to poor outcomes.
The brain does not like devoting energy to making these complex decisions, regardless of the importance we place on them. From a survival perspective, the brain is more focused on primitive functions, like breathing, that are relatively easy, and the brain is used to making. In short, the brain is lazy in making these complex decisions and has created shortcuts or rule-of-thumb strategies called heuristics to help govern these decisions. Whilst these heuristics are often very useful in helping us swiftly cope with the many decisions we make; they are not always based on logic and may not lead to the desired outcome.
The problem with heuristics is they are fuelled by cognitive and emotional biases. There are hundreds of biases which can affect our decision making. I’ve identified below some of the common ones which impact our financial decision making:
Loss aversion – a loss has a bigger emotional impact than a corresponding gain of equal magnitude. Research by Kahneman and Tversky indicated that the pain of a loss typically impacts us twice as much as the pleasure of a gain.
Confirmation bias – we seek views or data that reinforce our own opinions and dismiss those which contradict it without full consideration of merit or validity.
Anchoring bias – the fixation to an historic or milestone number which is arbitrary, eg, not selling assets until they exceed what you paid for them.
Endowment bias/inertia – the preference to stick with the incumbent or not make a change, eg, not doing a comparison search when car insurance comes up to renewal.
Overconfidence bias – thinking we know more than we do and can predict events like market downturns or rallies.
Extrapolation – assuming that future trends will continue based on history, eg, share ‘X’ has grown at Y% over the last 5 years so it will continue to grow at Y% in the next 5 year period.
Being aware of biases is the first step in trying to overcome them, but awareness on its own is not always sufficient given that these biases are often powerful and deep routed in our psyche. Discussing decisions, particularly with professionals who are removed from the individual’s personal biases, is often the best way to counter these biases and make more informed and logical decisions. Whilst professionals can have their own biases (which are not irrelevant), professionals are trained and experienced in ignoring these biases in the field in which they operate. In addition, many professions are regulated and controls are in place to limit the potential impact of these biases. For example, a judge cannot give a life sentence to a shoplifter just because they do not like the criminal concerned or find stealing morally repugnant.
Despite regulation, awareness of biases and best efforts, making decisions is rarely an exact science, especially when it is based on unknown future events and statistical probabilities. One should not necessarily look at the outcome or with the benefit of hindsight when weighing up whether a decision was good or bad. Regret can unduly create a bias for future decisions, potentially creating a systemic bad habit such as procrastination. One must accept that a decision can only be made to the best of one’s ability and with the information available at the time of making. This is not to say we cannot learn from our previous decisions (and mistakes) but they should not define the next decision we make.
This article was prepared by James Martin, a Financial Planning Consultant at CAM. We always appreciate your feedback. If you have enjoyed this article or have any specific topics you would like to see addressed in future newsletters, please email us at FPTeam@city-asset.co.uk.