Have you ever gotten into a “who is the best of all time” discussion with a friend? Maybe you’re talking about a movie, music, actor, etc. You might be a huge fan of Michael Jackson or the movie Titanic, but you can’t assume everyone shares the same sentiments. Because while you may love “Thriller” and Leonardo DiCaprio, your friend might not.
But how is personal taste relevant? Your preferences or tendencies could be connected to personal biases.
According to Psychology Today, "a bias is a tendency, inclination, or prejudice toward or against something or someone." Some types of bias are positive, like jamming to your favorite musical icon or watching classic movies because they are the “best.” It could also be staying away from someone or something that knowingly causes harm, like eating fast food every day (yeah, we all do it sometimes).
But, some biases are rooted in stereotypes rather than actual knowledge of an individual or circumstance. In either scenario, positive or negative, taking these “cognitive shortcuts” can result in premature judgments, leading to a “knee-jerk” decision or potentially discriminatory practices.
This blog is all about taking a look at how these types of biases can impact your money and overall financial plan.
- Financial biases can greatly impact your money and overall financial plan.
- Financial biases are relatively common, and we can inherit them from our families.
- A commonality with most financial biases is the fear of risk. Becoming comfortable with the right amount of risk helps combat certain biases.
Let’s take a look at some different types of financial biases, examples of how those biases can manifest, and most importantly, how to overcome them.
What Do Biases Have To Do With Finance?
So, where does money factor into all of this? You may be surprised to learn that some biases directly relate to finance. In fact, in a behavioral finance study, 98% of respondents exhibited one or more financial biases. That’s a whopping percentage!
The same study found that a person’s levels of bias (how low [weak] or high [strong] they were) correlated with their overall financial health. For example, respondents with low levels of bias reported were almost three times as likely to spend less of their income and more than seven times more likely to plan ahead for the future.
On the other hand, those with high levels of certain biases showed lower savings and 401k balances.
How We Help You Identify Potential Biases
Do you remember the feeling when you received your first paycheck? That first taste of financial freedom can tell us a lot about potential biases you may have carried throughout your life. If your immediate reaction was to spend a majority of it on some new shoes rather than save, that reveals more than you might think.
Like many other things, we can inherit potential biases from our parents/caretakers! Who did or didn’t teach you about money? What do you remember witnessing throughout your childhood in terms of financial matters?
By looking to the past, we get a glimpse into your potential future financial decisions.
With that in mind, let’s jump into a few different types of financial biases.
Core Types of Financial Biases
Today, we’ll examine five types of financial biases. You may already be familiar with some of them!
- Present Bias
- Base-rate Neglect
- Overconfidence/Limited Attention Span
- Loss Aversion
- Confirmation Bias
Each of these biases has its own way of potentially manipulating how you make financial decisions. Let’s dive into each of their nuances and some real-life examples to help you learn how to spot—and avoid— them.
Have you ever weighed the immediate returns over long-term goals? Do you only look at what's happening now instead of considering what's in front of you? In a nutshell, this bias focuses too much on the present and not the future.
For example: Overpaying for something now and sacrificing retirement savings.
This is the tendency to judge the probability of something happening based on new, easily accessible information while ignoring original assumptions.
For Example: Overreacting to new information on stock performance, selling shares of a stock based on bad news, or purchasing excessive shares of a stock based on good news.
Overconfidence/Limited Attention Span
If you exhibit this bias, you overestimate your abilities to make the right financial decisions or quickly make decisions based on limited knowledge.
For Example: You may think you know a great deal about cryptocurrency, so you might be more likely to buy a new digital coin without adequately understanding the risks.
No one likes to lose! This bias manifests as the tendency to be overly fearful of financial losses relative to gains.
For Example: Hesitating to sell a failing stock because you don’t want to acknowledge the loss. But, it may be in your best interest to sell and re-invest in a more promising stock.
In addition to not liking to lose, we tend not to want to be wrong. With confirmation bias, those that exhibit its symptoms specifically seek out information that confirms their own personal opinions.
For Example: You may foresee a stock performing a certain way, so you seek out/gravitate towards information that confirms your forecast.
Okay, so you may have discovered that you relate to one (or more) of the biases. But don’t panic! There are things you can do to alleviate their effects and keep them from clouding your financial success.
Keep Your Values at the Forefront
First, and most importantly, sticking to your values and investing strategy is crucial. Ask yourself what’s truly important to you and how you can manage your money to help you get there.
At AVID Planning, we stress the importance of “purpose-driven money.” Further, we mean your wealth has a greater impact on your life than it seems on the surface. By building wealth, you can achieve your financial and personal goals. Let your goals and values be the driving force behind your financial decisions.
Set Guidelines, and Follow Them
Let’s face it: following the rules can be hard. But it’s beneficial when overcoming financial biases!
For Example: You see that one of your larger stock investments is declining. Rather than deciding to switch up your investments, first, ask yourself if your long-term goals or investment strategy has changed.
Doing this allows you to consult with your financial advisor and evaluate if the switch is truly a positive adjustment and not an emotionally based decision.
Be Comfortable With The Right Amount Of Risk
Unfortunately, some risk is unavoidable in the financial world. But, there are things we can do to help make safer financial decisions.
Always make investment decisions with a margin of safety. Like you’ve heard a million times before, don’t put all your eggs in one basket! By working with your financial advisor, you can create a diversified portfolio that suits your goals, values, season of life, and risk tolerance.
By deep diving into our financial behaviors and potential biases, we can learn so much about your goals and financial values. That in itself is the main difference between just financial planning and financial life planning. By working with us at AVID Planning, we’ll work with you to help you reach your financial goals so you can live your best life.
We’d love to work with you. Please set up a time to chat with us today.