One of our favourite books is ‘Thinking Fast and Slow’ by Nobel Prize winner Daniel Kahneman. It reminds us that one of the hardest things for people to do is to make objective financial decisions.
So, when it comes to making better financial decisions, we need to be aware of the behaviours or mental shortcuts that might sabotage us.
Let’s first refer back to ‘Thinking Fast and Slow’. In the book, Kahneman describes two systems of thinking and behaviour.
System one thinking operates automatically and quickly with little or no effort, and no sense of voluntary control. It can be equated with the fight or flight reaction.
System two uses mental effort and does complex computations.
Many of us think of ourselves as identifying with system two – the conscious, reasoning self, that makes choices and decides what to think and what to do.
So what does this have to do with financial planning?
As we go through life, we all experience moments when we have to make a quick decision, or we need to think about something in more detail.
We use both systems of thinking all the time, and each of them can be a barrier to financial satisfaction.
A financial planner can spot these barriers and help clients overcome them.
What 6 mental shortcuts do people engage when making financial decisions?
1: The Confirmation Bias
With the confirmation bias, there’s a bias towards believing anything you’ve heard that supports your already formed point of view.
It is the uncritical acceptance of suggestions that confirm the likelihood that something improbable might happen.
This is system one thinking and it will also pull from memories to confirm whatever is being presented to us to believe.
It’s only really when we pause, think, and consider what is being said that we can methodologically test what has been presented to us.
The most effective way to deal with this concept of behavioural finance is to be the devil’s advocate and always to look at the opposite side of the argument. To look into each opinion with an objective frame of mind.
2: The Availability Bias
When making a decision, the brain tends to veer towards the probability of an event that has happened more recently, and it will bring up examples in your own mind.
This is to help you make a decision faster, but the frequency of events that have occurred recently and ease of recall affect your judgment.
For example, if there is an ad on TV about lottery winners showing off their wealth, you mistakenly think that your chances of winning are higher than they actually are.
The advert leaves a strong impression on your mind and makes you feel lucky.
The property boom is another example. The Irish media constantly reported only favourable, positive information, which led a lot of people to believe that property investment would only continue in a positive vein.
3: The Overconfidence Bias
This is overconfidence in the quality of the information that you’re looking at, and overconfidence in your ability to make decisions based on this information.
Overconfidence is the tendency of a person to overestimate their own abilities, which leads the person to think that they’re better than others, for example, the average investor. Thinking that you know better than the experts may lead a client to make mistakes.
Financial planners can counter the overconfidence bias by encouraging clients to make room for the other perspective.
4: Gambler’s Fallacy
People can incorrectly believe that a certain event is less likely to happen after a series of events.
An experiment was done involving tossing a coin 20 times. It came up heads all 20 times. The gambler would possibly believe that the next throw is bound to be tails. Statistics will prove that it has the exact same chance of being heads or tails.
Using the gambler’s fallacy in looking at investment decisions, for example – if a market has gone up for a long time, the gambler may think that it’s less likely to continue going up.
What the financial planner will do is take a long-term view with the client, research the opportunities and ensure that the client is sticking to their plan, and not taking short-term inputs in making long-term decisions.
This is when we make a decision based on a recent reference point.
One of the most famous anchors that we’ve seen is the notion of the diamond anchor. The jewellery industry says it’s good if you spend two months’ salary on an engagement ring. But this is entirely made up.
In fact, it has no relation at all to the love that you might feel for your fiancée. You should only buy a diamond ring that you can afford. Many men have gone into debt because they’ve bought expensive rings and then struggled afterward.
In the investment world, this is the same. If the market was trading at 1000, and today it’s at 800, people might think that that’s cheap.
But you must look at the valuation of the market and determine if it is cheap or not based on the returns that the market could possibly generate going forwards. A financial planner will remove the anchor. They will look at the market in an objective way and help you make good financial decisions.
6: Herd Mentality
Herd mentality is where people mimic the behaviour of a large group of people, follow a trend or follow the crowd.
There are two reasons why people do this.
One – they want to be with the in-crowd, they want to be part of the club.
Two – there’s a general sense that it’s unlikely for such a large group to be wrong.
The real problem with following this is that you could be following a trend or a fad that hasn’t been thoroughly researched. It might be the product of some marketing guru trying to establish a product as the latest, greatest thing that everybody needs to have.
Maybe cryptocurrencies are part of this today. We’ve seen it in the.com boom and in the property market here in Ireland. People think, “If Joe, John, Will, and Kathy are doing it then I need to be doing it just the same”.
What the financial planner will do is look at these fads and take a critical eye and help you decide whether or not investments are appropriate for you, and if it fits in with your long-term plans. If you want to know the difference between a financial advisor and a planner, you can listen in here.
Chasing appropriate returns
The fact is that chasing returns needs to be appropriate. A financial planner will determine the return that’s required to get you to your enough.
What is it that you need? There is zero point in chasing risk if, at the end of the day, you have more money than you’re going to need.
A financial planner will calculate for you and help you decide what is your enough, as opposed to simply chasing returns for the sake of returns.
Financial plans based on fact and not rules of thumb
In our experience, we’ve seen people get sucked up in heuristics like these.
While these mental shortcuts can be helpful in times of stress or difficulty, they can also be damaging in terms of people making good choices about finances.
A financial planner is trained to spot the dominant rules of thumb that people use, and to help them look with a critical eye and decide whether or not the decisions that they’re making are suitable for them.
We can create a holistic financial plan for you, taking into account all your goals and objectives, all your desires, and what you’re going to need to achieve those. We base decisions on fact – and not rules of thumb or heuristics.
A financial planner is well-trained with experience in helping clients to develop their plans on real information. They help you avoid those pitfalls that can come up in time.
If you would like a conversation with us, give us a call or drop us a line on info at foundation stone fp.ie.
To hear more about this topic, listen to the Navigating Money Podcast.
Foundation Stone Financial Planning Limited is regulated by the Central Bank of Ireland.