By Rosie Murray-West

Reading time: 5 minutes

Rosie is an award-winning personal finance, news, financial and features journalist. She has written widely for The Times, The Sunday Times, The Mail on Sunday and for the Daily and Sunday Telegraph.

WHEN faced with a dilemma, we are often told to trust our instincts, but when it comes to managing our money, our instincts are all too often our worst enemies.

Experts in so-called ‘behavioural finance’ believe that understanding how our minds work when it comes to handling money can help us to avoid making common errors- such as saving too little or selling our investments at the wrong time.

With this in mind, here are some of the most common ways that psychologists and behavioural finance experts say that we are getting money all wrong, and how we can use our understanding of them to get money management right.

  1. We fear loss more than we love gains

Rudyard Kipling’s famous If poem counsels us to ‘Meet with triumph and disaster/And treat these two imposters just the same’, but studies show that we are completely unable to do this. In fact, according to two academics called Kahneman and Tversky, we fear losing money roughly twice as much as we like gaining it.[1]

Why does this matter?

Loss aversion matters because it skews the way we invest, as well as the way we prioritise spending our money. For example, it can make us switch our investments to cash at the time when the market is dipping or leave our cash at the mercy of inflation in low-yielding accounts. It also makes us prey to what is called the ‘sunk cost fallacy’ – when we continue in a behaviour or endeavour because we have previously invested resources in it which we cannot recover.

This happens when you eat too much at an all-you-can-eat buffet (because you want to get your money’s worth) or force yourself to watch a film that you’ve paid for in advance, even if you’re too sick to get any pleasure out of the cinema visit.

In exactly the same way as you won’t pass up on the trip to the cinema, you won’t sell a stock or fund that’s gone down since you bought it, even though it doesn’t fit your plan, because of the sunk cost.

How can we bypass the problem?

Simply being aware of loss aversion can help us to ask better questions when we invest. Sometimes even knowing how your emotions play tricks on you can stop you making bad decisions. Another simple way to get round it is to automate your investing -so that you put a monthly amount into an investment fund that’s in line with your risk tolerance and appetite. This stops you obsessing about whether you are timing the market right, as well as smoothing out any bumps in the investment road.

  1. We think that what has just happened will happen again

Does seeing a car break down by the side of the road remind you to renew your AA cover? That might be a sensible decision, but you could also be the victim of ‘Availability Bias’.

Availability Bias happens when we overestimate the likelihood of an occurrence because it has happened recently, or because we feel emotional about a similar event.[2]

Why does this matter?

Availability bias affects almost all facets of our lives. So if you’ve recently been involved in an accident you’re likely to believe it is likely that you’ll be involved in another one – even though (unless you’re a terrible driver) there is no real reason why this should be so.

It works in the same way with your investments. Availability bias makes us overconfident just after the market rises, and underconfident just after it falls.

It also affects the way we buy insurance. Many of us are likely to insure against natural disasters just after an earthquake or volcano, but this effect decreases after the issue disappears from the news, even though we are just as likely to get caught out.

How can we bypass the problem?

As with all biases, knowing about the issue is the first step. Automation is another cure, or turning to an expert who can be more objective about investments. A good knowledge of how the stock market has performed over time can help you to overcome the idea that what’s happened in recent months will continue to be the case.

  1. We are swayed by the irrelevant

When we save and invest, we should also be aware of a phenomenon known as ‘Anchoring Bias’. This refers to our tendency to ‘anchor’ our feelings about something to reference points that are not relevant to the decisions we are making.[3]

Anchoring bias comes into play when we look at two products that are for sale for the same price, but one has been previously discounted. The discounted product’s original price should have no bearing on our decision to buy one product or the other, but this irrelevant ‘anchor’ often leads us to believe that the discounted product is better.

Why does this matter?

Anchoring bias leads to us making less than ideal financial decisions. For example, we may ‘anchor’ our perceptions of the value of a stock or fund to a high historic price that no longer has any relevance. Anchoring can also be a problem with our pension savings – we’re quite likely to ‘anchor’ our contributions to the minimum level set by an employer, or by the Government, and subconsciously believe this is best practice.

How can we bypass the problem?

Exploration of different ways of valuing stocks – such as price earnings ratio – could help you to view their value through a different lens than simple past performance. With pension contributions, using tools that predict the performance of your retirement fund over time could help you to create a more relevant anchor for your contributions, that would help you achieve your own goals.

There are many more cognitive biases that can affect our investment decisions. If you are interested in knowing more, some good books on this subject include Thinking, Fast and Slow by Daniel Kahneman and How We Know What Isn’t So by Thomas Gilovich.

Overcoming these biases can help you to be a better investor, as well as a more active participant in your own decision-making processes in other areas of your life.

[1] https://www.jstor.org/stable/2937956

[2] https://www.researchgate.net/publication/224916547_How_Do_People_Judge_Risks_Availability_Heuristic_Affect_Heuristic_or_Both

[3] https://www.sagu.edu/thoughthub/the-affects-of-anchoring-bias-on-human-behavior