Making Intentional Financial Decisions To Avoid Falling Victim to Biases

Your feelings are always valid, but that does not always mean your instincts are right. Because you feel something doesn’t necessarily mean you should act on it. The human brain is wired for our survival in a harsh physical world, but that often means that we are not programmed to make the best decisions when it comes to modern society. Our financial decisions our often negatively impacted by our instincts.

Immediate Safety v. Calculated Risk

In financial planning and investing our instincts frequently lead us astray. Our brains seek immediate safety, not calculated risk. When we make a plan for our money it is important to stick with it through the ups and downs. This will help us receive the sought outcome that we planned for.

Our brains tell us to seek safety at any cost. In investment terms this translates to “the price is falling, time to sell.” One of the basic principles of investing is that you want to buy when the price is low and sell when the price is high. This is contrary to our instincts.

When we make investment and other financial decisions based upon instinct or emotion we are much more likely to lose money. This is why investment advisors will frequently recommend that clients, who are in a panicked rush to sell, hold the course.

Spending is another area in which our instincts may not serve us. Retailers know this and that is why they push the concept of scarcity through means such as limited time offers. Our instincts tell us “this is my only chance, I need to act now.” In reality, we benefit from making intentional calculated purchases in which we assess our need and compare prices and products.

Cognitive Biases

I recently heard an interview in which behavioral finance researcher Graeme Newell discussed the topic of making decisions. Norton discusses many of the cognitive biases that can lead to poor financial decision making.

When we talk about our instincts, there are many ways that our instincts may fail us. This does not mean that we should ignore our instincts and we should never trust our guts. We should, however, take into account all of the factors influencing our instincts. Extensive research in behavioral finance has exposed the ways our brains may be biased in the financial decision making process.

One of these biases is called availability heuristic fallacy. In the above interview, and also on his video blog, Norton discusses this concept. This bias says that we over estimate the value of information that we can vividly recall. In other words, if something happened recently we believe it to be more true.

So, how does this impact our financial lives?

We may think that we are making informed, researched, objective decisions when, in actuality, availability heuristic bias is at play. We are disproportionately relying upon our recent experiences rather than weighing all experiences equally.

I worked in client service at T. Rowe Price during the tech boom of the late 90s (yup, I’m aging myself here folks). I spoke to many people who wanted to invest all of their money into the TRP Science and Technology Fund. The fund had received huge returns and they wanted in on it. I tried to educate these investors about diversification and stock market risk. In response, I heard over and over again “That doesn’t apply anymore. This is a new paradigm.”

Clearly, history proved them wrong. The tech bubble burst in 2001 and a lot of investors lost money. Turns out it was not a new paradigm, just a case of an over valued sector of the market that eventually corrected.

It is easy for us to scoff at the comments in hindsight. But, at the time, people really thought that the new world being created by technology was changing everything. Investors’ most recent experience was of years of growth in the tech sector. Market downturns were further in the past and did not feel as likely. The recent memories outweighed the historical ones and led to investors making poor financial decisions with substantial consequences.

In addition to investing, there are other ways that the availability heuristic fallacy can affect our financial decisions.

For example, the insurance industry benefits greatly from this bias. If you are ill shortly before the enrollment period for your medical plan, you are likely to purchase a more comprehensive plan. The purchase of flood insurance increased drastically after hurricane Katrina.

Planning Helps Overcome Biases

It can be very challenging to respect our instincts, honor our feelings, and to make sound financial decisions. We are human and our choices will be based upon our humanity, not strictly upon logic or formulas. But, we can make intentional financial decisions by making plans and sticking to them. Awareness of how biases may influence our thinking can keep us from giving into them and can empower us to stay the course.

Maura Madden is a registered investment adviser in the State of Washington. The Adviser may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Individualized responses to persons that involve either the effecting of transaction in securities, or the rendering of personalized investment advice for compensation, will not be made without registration or exemption.