Join financial planners Dervla Moloney and David Lunn as they discuss the six mental shortcuts that people use when making financial decisions. They explore each of the six heuristics and explain why financial planning should be based on facts and not these rules of thumb.
Podcast Transcript:
David Lunn – 00:33
Thinking fast and slow – two systems of thinking and behaviour
One of the great things that a financial planner will do with a client is to help them understand some of the behaviours that they can exhibit, especially when it comes to investments. One of my favourite books is ‘Thinking Fast and Slow’ by Nobel Prize winner Daniel Kahneman.
In it, he describes two systems of thinking and behaviour. System one is the one that operates automatically and quickly with little or no effort, and no sense of voluntary control.
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.
System one can be equated with the flight or fight reaction. So what does this have to do with financial planning? In truth, we use both systems all the time, and each of them can be a barrier to financial satisfaction. A financial planner can spot these barriers and help our clients overcome them.
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. Heuristics are things like herd mentality, mental maths, estimation, and they are behaviours that we exhibit.
Dervla Moloney – 1:58
1: The Confirmation Bias
I’m going to talk about three different heuristics. David referred to the book by Daniel Kahneman ‘Thinking Fast and Slow’. And I suppose this book, and the way he talks about fast and slow thinking, has an impact on all of the different heuristics we’re going to talk about.
So the first one I’m going to look at is the confirmation bias. And again, this refers back to system one and system two – system one being fast, almost gut reaction is biased towards believing….so if you’re thinking using system one, you’re automatically going to believe anything you’ve heard.
The system two, which is a more conscious and purposeful way of thinking, is more in charge of doubting and unbelieving.
So with the confirmation bias, there’s a definite bias towards believing and system one, so it favours the uncritical acceptance of suggestions or exaggerates the likelihood that you’re going to believe something improbable might happen.
So, unless we’re playing paying very close attention, and really engaging ourselves in system two, our bias is always going to be to believe what we’re told.
System one which is fast and automatic will always pull memories, I suppose from the short term and ideas as for minds to confirm, whatever is being presented to us to believe, but it’s only really when we pause, think, and consider what is being said that system to get the chance to 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, and to look into each opinion with an objective frame of mind.
And looking at this in terms of the investment world, I suppose Warren Buffett was one of the most successful investors in the world, he’s always said that “A good investment analyst must be able to challenge their own ideas”, and really, he looks to see that there’s the rapid destruction of your own ideas when the time is right, this is always one of the most valuable qualities you can acquire in the investment management’s environment when you’re trying to make investment decisions, and you must force yourself to consider the arguments on the other side.
So if we only ever engage in system one, we don’t really get to the other side to look at the other side and the other argument, so you really have to engage system two and be the devil’s advocate, and I suppose that’s where the financial planner can help with investment decisions, and we’re trained to do that when we’re looking at investment plans.
And obviously, being human ourselves financial planners will have that confirmation bias on board, so it’s very we’re very much conscious of that and aware of that. And I suppose that’s why we from day one would put together a very structured plan with the client in terms of their financial plan or financial journey, and all the way through, no matter what kind of news or events are triggered, we would always try to engage and be very conscious that we’re engaging with system two looking at both sides of the argument, and always going back to where we started, which was the original plan, rather than making short-term, knee-jerk reactions, if there’s some sort of a bubble in markets or if there’s a herd mentality, or if there’s a number of different heuristics going on, we step back and we look to look at both sides of the argument and look at both sides from a financial perspective.
Dervla Moloney – 4:54
2: The Availability Bias
So just in terms of the availability bias, I suppose, just to recap. We’re talking about the two different ways of thinking, how our brain works. So basically system one, being the fast way and system two being the slow more conscious way, when we’re looking at the availability bias. Again, the mental shortcuts here when making a decision, the brain tends to the probability of an event that has happened more recently and that is very easy to bring up examples in your own mind, will lead you towards making a decision much faster. So the frequency of events that have occurred recently and ease of recall will actually affect your judgments. So in simple terms I suppose prefer saying here is – one guesses the likelihood that things have happened by recalling recent memories as a reference. So for example, in the case of the financial world again, if there are ads on TV or lottery winners, there’s a coming up with this, you see them on the TV regularly advertising for people that have won the lotto with their fancy houses or their big lovely slides going through the house is one of the ones on currently – it’s showing and depicting luxurious lives of these people that have won the lotto so then you mistakenly think that your chances of winning the lotto are actually higher than they actually are statistically.
And why does this happen? It happens I suppose because the documentary leaves a strong impression on your mind, which is easy to recall because you’ve just seen it. And this makes you feel lucky, and you think that maybe there’s a better chance that you might win the lotto than actually is the truth which statistically is very, very unlikely.
This I suppose is another example in terms of this availability heuristic is the property boom back in 2007. Once again, as was the Irish media were constantly reporting only favourable, positive information, which really led a lot of people to believe that that’s the only way property could go was to continue in a positive vein.
Dervla Moloney – 6:38
3: The Overconfidence Bias
The third heuristic we’re going to look at is the overconfidence bias. So overconfidence in the quality of the information that you actually are looking at, but also overconfidence in your ability to actually make a decision based on this information. So, overconfidence is the tendency of a person to overestimate their own abilities, and it leads the person to think that they’re better than, for example, the average driver, if we’re thinking of in the driving scenario, or they’re better than the expert investor if it’s in relation to their own finances. So, overconfidence may lead a client to make risky mistakes. I suppose that’s where the advisor comes in and we might be able to counter the overconfidence bias by encouraging clients to make room for the other perspective and going back to step system one and system two, the whole idea of Thinking Fast and Slow – system one being the fast part system to be the slower thinking – we I suppose need to work with the client at certain points on the journey of the financial plan to ensure that they’re engaging in system two and really thinking about the more detailed analysis and the more detailed numbers, rather than just making fast decisions on based on system one.
So, another example I suppose, of this overconfidence bias, goes back to be again to the Irish media and constantly reporting only positive news and information in relation to real estate pre the bubble and the bust, despite us was a series of international reports, including those from the OECD, the IMF warning the property prices were too high based on economic fundamentals. But again, nobody was engaging the right looking individuals will still continue to buy property, thinking that the media reporting, it was exasperating I suppose their overconfidence that the investors had themselves and leading them to see property as a one-way bet, which in turn leads to pushing the prices up and obviously, then the continual improvement exaggeration in property prices.
Dervla Moloney – 8:29
Okay. So just in summary on those three different biases we have spoken about like confirmation bias, availability and overconfidence it really comes back I suppose again to the, to the title of the book by David Canavan which is Thinking Fast and Slow, really, a system one is thinking fast, system two thinking slow, and I suppose you’re really engaging with a financial planner to ensure that you’re thinking about financial decisions using both systems – you can’t always use system two, but in the longer-term planning system and looking at your financial plans longer-term, it’s very important to engage in system two with the financial advisor or planner to try and get the best potential outcome with the part of financial assets that you have.
David Lunn – 9:09
4: Gambler’s Fallacy
I really like two particular heuristics that people fall foul of. One is called the gambler’s fallacy; people incorrectly believe that a certain event is less likely to happen after a series of events and the experiment that was done was tossing the coin 20 times and it came up heads all 20 times. The gambler would then possibly believe that the next throw is bound to be tails. In fact, statistics will prove that it’s actually exactly the same chance of being heads or tails. And if you use the gambler’s fallacy in looking at your investment decisions. If a market say gone up for a very very long time. The gambler may think that it’s less likely to continue going up. And the problem with that is, it’s only short-term that they’re looking at, they’re not considering the very long term and whether it’s right or wrong for them to be investing. And what the financial planner will do is take a very long-term view with the client, will research the opportunities and ensure that the client is sticking to the plan and that they’re not taking short-term inputs in making long-term decisions.
David Lunn -10:23
5: Anchoring
The next heuristic or rule of thumb that I like is described in the literature and as anchoring. And this is when we make a decision based on the recent reference point. It’s interesting, one of the very famous anchors that we’ve seen is the notion of the diamond anchor, and that’s where the jewellery industry has put it out there that it’s good if you spend two months’ salary on an engagement ring. This is entirely made up. And in fact, it has no relation at all to the love that you might feel for your fiancée. The fact is that you should actually buy a diamond ring that you can afford. And many men have gone into debt because they’ve bought these expensive rings and then struggled afterward.
And in the investment world, this is very much the same. If the market was trading at 1000, and today it’s at 80, people might think that that’s cheap. But what you have to do is have a look at the valuation of the market and determine if that is relatively cheap or not, based on the returns that the market could possibly generate going forwards.
And this is where a financial planner will help you. They will definitely remove the anchor. They will look at the market in an objective way and help you make good financial decisions.
David Lunn – 11:46
6: Herd Mentality
The last one that I want to talk about is herd mentality. This is where people mimic the behaviour of a large group of people – i.e. follow the trend or follow the crowd and 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. And two, there’s a general sense that it’s unlikely for such a large group to be around.
The real problem with following this is that you could be following a trend or a fad that hasn’t been thoroughly researched or is the product of some marketing guru has decided that this is the latest, greatest thing that everybody needs to have.
And I’ve seen this many many times in the markets. And one could argue that maybe today cryptocurrencies are part of this, but we’ve seen it in the.com boom; we’ve seen it in the property market as Dervla has already said here in Ireland, where “If Joe, John, Willy and Kathy are doing it then I need to be doing it just the same”. And what the financial planner will do we’ll look at these fads and take a critical eye, and decide whether or not they’re appropriate for you, and do they fit in with your long-term plans.
David Lunn – 12:59
The fact is that chasing returns needs to be appropriate, and the financial planner will determine the return that’s required to get you to your enough. What is it that you need? There is absolutely zero point in chasing risk if, at the end of the day, you have more money than you’re going to need. And the financial planner will do that calculation for you and help you decide what is your enough, as opposed to simply chasing returns for the sake of returns.
And in this way will help you avoid the herd behaviour and the latest fad, and the hottest greatest latest things.
David Lunn – 13:37
Financial plans based on fact and not rules of thumb
In our experience, we’ve discovered and seen people get sucked up in heuristics, many many times. And whilst they can be very helpful in times of stress or difficulty, they can also be very damaging in terms of people making good choices about their finances. A financial planner is trained to spot the dominant rules of thumb that people use, and to help them look at them with a critical eye and decide whether or not the decisions that they’re taking are suitable for them. By the creation of a holistic plan, taking into account all your goals and objectives, all your desires and what you’re going to need to achieve those, we can actually base decisions on fact – and not rules of thumb or heuristics.
David Lunn – 14:31
Our real message is that financial planning should be based on fact. And not rules of thumb or heuristics, and a financial planner is very well positioned, trained and has experience in helping clients to develop their plans on real information and help you avoid those pitfalls that can come up in time.
And if you really would like a conversation with us, just to see how we work, what it is that we do for our clients and how we can help you avoid some of the classic pitfalls that people fall into then please give us a call.
Dervla Moloney – 15:17
Thanks so much for listening in to the Navigating Money Podcast with Foundation Stone Financial Planning Limited. If you’d like to chat with us about your financial present and future, drop us a line on info at foundation stone fp.ie.
David Lunn – 15:31
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