Faced with a financial decision, human beings do not always choose the option that might seem most plausible in terms of cost, return or risk. This is because, when making the decision, there are factors that, not being linked to the intrinsic nature of the decision, weigh in a relevant way in it, as may be the case of the psychology of decision-making and the influence of the environment.
In this sense, by way of example, it is worth highlighting the famous experiment carried out by the eminent psychologist Solomon E. Asch, who tried to highlight the extent to which social pressure from a majority group influences a person when it comes to make a decision.
Returning to the financial aspect, as highlighted in the introduction to this module, it is not enough to know every implication of the financial product throughout its life, but it is also necessary to be aware of the cognitive biases that the investor faces when making a decision to try, in this way, to minimize the impact of behavioural biases.
A list of the most common cognitive biases when making a financial decision along with an explanation of them can be found below:
- Retrospective. This bias refers to the propensity of the person to forget failures and give preponderance to the successes they have achieved in their track record of financial decision-making in the past. Furthermore, successes are usually attributed to the decision maker, while failures tend to be explained by looking for excuses or blaming on factors beyond the control of the person who made the decision.
- Prominence. According to this bias, the person pays attention to the most prominent characteristics of a financial product. Consequently, the person will give greater importance to these characteristics over others that could be equally important.
- Availability. When making a financial decision, the person has information that has been collected from various sources. If certain information or aspects of the information are more available or accessible, this will make the person to believe that what this information conveys happens more frequently.
- Representativeness. This bias refers to the estimation of the probability that an event (X) takes place derived from the occurrence of another event (Y). Therefore, a correspondence is established between the event X and Y, or in other words, having happened Y, it is possible to estimate the probability that X occurs. However, this bias makes the person tend to think that X has occurred because Y has happened, when in reality X is not fully explained by the occurrence of Y. For example, if GDP grows, it is normal to think that equity markets tend to rise.
- Tendency to reduce remorse. This bias is related to remorse and how it affects the decision-making process. In order to avoid feeling remorse, a person may be tempted to avoid acting on, for example, an investment that has proven negative over time. Instead of selling this asset and proceeding to consider better options, the investor may feel predisposed to continue this investment in order not to sell it so as not to feel remorse.
- Capture trends. When an investor detects a trend in a financial product, the investor may feel compelled to invest in that financial product, believing that the trend detected based on past data be prolonged in the future.
- Limited attention span. According to the economist and psychologist Herbert Simon, humans are limited by what they called “bounded rationality”: Humans make decisions based on the limited knowledge they can accumulate. Therefore, instead of making the most efficient decision, they will make the most satisfactory decision.
- Overconfidence. This bias refers to the tendency to overestimate subjective knowledge and judgments and consider them accurate. Overconfidence can lead the investor to consider that the probability that their investment will fail is lower than it really is.
- Control illusion. It is the tendency to overestimate that the investor has the control or the possibility of influencing a situation. This bias can lead to the assumption of a level of risk higher than the adequate when trusting that the fluctuations of the market are controlled thanks to the analyses carried out and the information available.
- Confirmation. It consists of interpreting the information received or looking for new information in a way that corroborates previous convictions or ideas. In this way, investors selectively seek information to support their opinions instead of seeking opinions or critical reports with them, with the consequent risk of not making an appropriate investment for them.
- Anchorage. It is the predisposition to give more weight to the information received in the first place than to a new information that contradicts it. Its name is because these previous ideas sometimes represent real anchors that are difficult to release. In the investment world, this bias is frequently appreciated, for example, when the return of an investment product is presented first and other data not as positive as the associated risks are no longer considered, or it is taken as a reference of the evolution of a share the price it had in the past.
- Authority. It is the tendency to overestimate the opinions of certain people simply because of who they are and without subjecting them to prior judgement. It may happen that an investment is made solely because it is recommended by a family member or a friend without carrying out any additional analysis and without taking into account your own needs and risk profile.
- Halo effect. It is the predisposition to judge a person or institution on the basis of a single positive or negative quality that overshadows all the others. It is a very frequent bias in the investment field, so that a financial product tends to be classified as good or bad based on a single piece of information, for example, the results of the company or the popularity of the marketer or manager of the financial product in question, without considering that this financial product may not be adequate for the intended investment objective or for the own risk profile.
- Social proof. It is the tendency to imitate the actions carried out by other people under the belief that the correct behaviour is being adopted. This bias occurs in situations in which the subject does not have a defined idea of how to behave and is guided by the behaviours of others, assuming they have more knowledge. In making investment decisions, the investor could be dragged by the decisions of other people and make investments that do not favour them only because others do.
- Hyperbolic discount. It is the propensity to choose smaller and immediate rewards over larger and distant in time rewards. It is because the immediacy of the rewards has a great power of attraction. The hyperbolic discount can lead the investor to undo an investment designed for the long term and suitable for their profile due to an eventually attractive evolution of the markets or the appearance of more profitable financial products, thus altering the initial objectives and entailing associated costs and risks.
- Loss aversion. This bias refers to the tendency to consider that losses outweigh gains. In other words, the fear of losing something is a greater incentive than the possibility of gaining something of similar value. When investing, it may happen that, as long as not incurring losses, an investment with minimal prospects for recovery is maintained and everything invested ends up losing. Likewise, this bias can lead to the so-called myopia effect, which is especially detrimental to long-term investors, causing them to continually assess the value of their portfolio and overreact to news and events that occur in the short term. Myopia makes the investor lose perspective on their investment and the events that affect it.
- Status quo. This bias implies that the current situation is taken as a point of reference and any change with respect to that point is perceived as a loss.
- Endowment effect. This effect refers to the finding that people place a higher value on objects when they own them. So this means that giving away that object would be seen as a loss. The price at which a person is willing to buy a specific good or service is much lower than the price at which that person is willing to sell the same good or service.
- Mental accounting highlights that economic decision-making by individuals is segmented by categories so that there is a separate accounting for each group of expenses (housing, food, leisure…) which means that there is no integrated management. Common practice of having cash in a current account and at the same time having credit card debt illustrates this phenomenon.
- Individual perception about a transaction’s utility can be quite important, because decisions are made by the difference between actual and expected prices. The customer gets an added value if they can complete what they consider a “good deal”.
