Exploring biases that affect our personal finance decisions for better or worse.
Simple Money – Canada’s Own Personal Finance Podcast
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Another Brand New Episode!
Hello and welcome back to Simple Money podcast
Today we continue or discussion on biases that affect our personal finances and investment choices. As a quick recap, a bias is a tendency, prejudice or inclination that is for or against something. These internalized processes can then affect our financial decisions. If you want, you can check out the last episode for a more detailed summary about biases and heuristics.
Today we’re going to cover six more common biases that we should key an eye out for. Admittedly, all of us have these biases to varying degrees but we should be alert if they strongly control over our actions.
Loss Aversion Bias
First-up is a really common bias and one that we all have in some form or another and it’s called the loss aversion bias. Research has shown that we are more affected by a loss than a gain – even when a loss and gain are the same amount. In some studies, researchers have found that the emotional impact of a loss can be up to twice as much as a similar gain. In many cases the biases toward risk aversion can arise from negative experiences like past losses or seeing others in our social circle have losses.
When we overvalue risk, this can obviously affect our financial decisions and push us into investments that have reduced risk and in conjunction, typically returns. This then requires us to put more money aside to hit our financial goals and in some cases like retirement, this can be a considerable amount extra.
This bias perfectly transitions into the disposition bias. This is when we have tendencies to hold onto an asset that has declined in value and instead sell an asset that has accumulated in value. This translates into holding on to underperforming investments and prematurely selling investments that are performing well.
Overall, this can lead to reduced investment performance and tax considerations from selling investments that have been sold at a gain.
The next bias is called Sunk-Cost Bias
This bias arises when we have too much faith in a specific investment. Individuals that have this bias decide to spend your time, money, energy, and other resources to support an investment that has been shown through evidence that has expected benefits than expenses.
Using an example, a person may spend their time and money investing into a company that they think will do well even if evidence proves otherwise. In this case, they will suffer from losses and use up their valuable energy to continue their plan. The best bet here is to cut the losses early and redistribute the resources to a more profitable investment.
Anchoring and Adjustment
The belief that supports a sunk-cost bias can come from many places, including another bias called Anchoring and adjustment. This bias arises when we rely mainly on one piece of information when we make a financial decision. Which is often the first source of info that is encountered and afterwards have difficulty readjusting this information.
This bias can either have a for or against influence. A big gain in the past on a specific investment may lead them to have too much faith in an investment or a bad experience can conversely push them away. A common situation that I see is that an individual or a family member will have made an investment loss in the past and they will become risk adverse.
The Familiarity Bias
Making financial choices that are comfortable to you can also develop into a bias. The familiarity bias occurs when we believe too strongly in a specific investment or choice because we are familiar with it or that it’s well known.
This type of bias can lead to an under diversified portfolio and the possibility to miss out on certain types of opportunities.
Availability or Recency Bias
Finally, we come to or last bias known as the availability or recency bias. This bias follows from overestimating the probability of an event occurring if it can be easily recalled. The recency and emotional impact of the recalled event further affects one’s behavior. With more recent and emotional events having a larger impact. This bias can turn someone into more of pessimist or cause them to have overconfidence.