Behavioural biases in personal finance

People think economics and finance are about numbers but remember I said finance is not a hard science like physics but a social science …so actually about people. People make up the markets that we hear about…people like you and me called retail investors but also the professional fund managers called institutional investors. And we investors then give money to people who run the companies and governments. So investing is all about people…and we people are human … we can’t do math in our heads and we are emotional. So we need to be mindful about how we humans behave with our money.

Types of behavioural biases

The human brain is fascinating. We are still learning about how the brain works, both from a neurological perspective and psychological perspective. This means that we don’t really know why we do a lot of things we do.

When it comes to investing, what we know so far is that we have two brains, metaphorically…one that thinks very quickly and one that thinks a bit more slowly..mindfully. And a lot of times we just make decisions..and then justify them. This means we make errors….we call them behavioural biases.

These biases can be put into two categories –

Cognitive – are to do with the way we think; they result from memory and information processing
Emotional – are about how we feel; result of reasoning influenced by feeling.

Two types of cognitive –

• Belief perseverance – eg in spite of evidence showing sugar has no effect on children’s behaviour, people continue to believe it does; cognitive dissonance, conservatism, confirmation, representativeness, illusion of control, hindsight bias
• Information processing – anchoring, mental accounting, framing, availability, self attribution, outcome, recency

Emotional – loss aversion, overconfidence, self control, status quo, endowment, regret aversion, affinity

What to do about behaviroual biases

With emotional, advisers will need to adapt as it’s hard to change how people feel
With cognitive, advisers have opportunity to ‘moderate’ ie change thinking through education

Some experts feel there is a link between risk profiling, personality types and the types of biases the investors are likely to show.

Advisers could use different approaches to emotional vs cognitive client types. Reports to former should focus on how the investments are tracking on goals like retirement, security etc while those to latter could have quantitative analysis on Sharpe ratios etc.

Behavioural biases can be managed with coaches and advisers

The first step is to be aware of such behavioural biases. The financial industry has been educating about these for a while. Some providers have also started ‘nudging’ investors to make better decisions. But we all still may need to work with coaches and advisers.