Financial decision making is a crucial component of one’s life. Whether it be daily budgeting or long term investments it is often thought that our financial choices are simply shaped by facts and figures, this is only partly true. As humans, our emotional tendencies play a significant role in the way in which we process information, make decisions and evaluate risks. Our financial decisions are often influenced by underlying cognitive factors and the way which our psyche processes the information at hand. Being able to recognise and understand the influence that these cognitive factors have may improve our financial decision making skills.
The four cognitive factors that I will touch on are anchoring bias, overconfidence bias, loss aversion and mental account. These factors are often interlinked and can affect our financial decision making.
Anchoring Bias
When one receives a lot of information, we tend to place more importance on the first piece of information received. Initial information will become the ‘anchor’ of both immediate and future decisions. Anchoring bias will influence our financial decision making – but the information we base our decisions on could be outdated or even irrelevant. It is important to consider all information when making a decision.
When it comes to making effective financial decisions, it is important that one evaluates all the up to date and relevant information and not allow the initial data to skew the final decision.
Overconfidence Bias
Overconfidence bias is when individuals overestimate their knowledge and skills while underestimating the risk and consequences that are involved within the decision making. This bias is commonly linked to trying to time the markets to get the best return.
When investing it is important to evaluate all aspects of the investment, the potential gains as well as the risk involved. Having this holistic view of the investment aids one to make an informed decision by considering both the positive and negative outcomes. Looking at the bigger picture is important as the smallest bit of information can significantly impact the final decision.
Loss Aversion
Loss aversion is a complex cognitive bias within the context of financial decisions and investing. To put is simply, no one likes losing – especially when it comes to money. Loss aversion is when one tries to avoid losses at all costs and only achieve gains. In otherwards, the emotional impact of losing money is greater than the joy of earning it.
A loss when investing is bound to happen at some point. Many believe that in order to make a gain you have to incur a loss. It is part of investing – perhaps a short term loss with a long term gain. However, bias can lead investors to avoid necessary risk and miss out on opportunities if they aim to avoid any form of loss which results in them being overly cautious. Overcoming loss aversion is crucial for making well balanced investment decisions.
Mental Accounting
Mental accounting can influence decision making. Investors may tend to categorise their money and give it different values based on its origin or its intended purpose, rather than seeing it as the same. This form of bias can become a habit and will influence the way you see your money. The easiest way to explain this is through an example: if you receive a bonus, you will be more willing to make risky investment choices or spend the money as you see it as ‘extra’ money, whereas you will be more cautious when spending or investing your regular/main income.
Mental accounting skews an investors risk profile and misrepresents their long term financial goal. It is important to ensure consistent investment decisions that are in line with your own financial goals.
Recognising and understanding how cognitive factors shape the way that you interpret and process information as well as knowing how these factors can shape your subsequent decision making is crucial. Comprehending these factors can build and strengthen investment tendencies to achieve your greater financial goals.
