Do behaviour biases influence financial decisions?
The COVID-19 pandemic is shaking and shaping up a new normal around the globe with challenges and innovations that we have never seen before coming to life. At one end of the curve, we have seen a lot of people being unemployed and struggling to pay for basic necessities like food, rent or mortgage. And at the other end of the curve, we have seen people and businesses innovating and digitizing their processes to minimize their expenses to earn a decent income. Even though it is very soon to say how the pandemic will reshape financial decision-making moving forward, it seems like we all will be taking very cautionary decisions so that we don’t incur greater losses on our savings and investments. With all of this in mind, it is quite possible that your financial set-up (if any) does not meet your current lifestyle and needs. We have already seen people downsize their budgets, considering emergency funds, pulling out their retirement savings to meet their daily expenses, etc. and all of these actions may seem justified to us (and some are) but are there better decisions that could be made? The answer is Yes. And I could write many articles on the mechanics of personal finance — how to budget, use easy techniques to pay down debt, and perfectly allocate your retirement portfolio for age and risk tolerance. But most of you wouldn’t read it. It’s honestly very boring stuff and I would only be repeating what other writers have written about. In this article, I will write about how financial decisions are made and how we let a few biases influence our decisions. This has a lot to do with who you are: your personality, your environment, your friends and family. I need to do something! Back in those days (Pre-COVID), when driving back home from work, I usually find myself in traffic jams alongside Ngong Road. As soon as I see traffic building on this road, I often take other roads and you might have done this before to skip the traffic. Most of the time, this is almost very counterproductive as I end up taking a longer route, burning more fuel and also sometimes spending more time on the road if I get stuck somewhere. But moving and taking these “shortcuts” was more preferable than just sitting in traffic and doing nothing. This phenomenon is called “Action Bias”. Our natural emotion during unprecedented times or unpredictable times is to immediately take back control of the situation and act or do something. It doesn’t matter to us whether that action is a good idea or not. We should simply do something. This phenomenon is especially true in the finance world. When a crisis like COVID hit Kenya, it was quite natural for long term savers to abandon their investment strategy and pull out their savings or move their savings to less risky financial products. And this may not have been the best strategy. What should you have done? Stick to your investment strategy. As a smart investor, you would have carefully considered this risk in the first case. Even though a pandemic like COVID was highly unpredictable and could have not been factored in a financial plan. For now, talk to a financial expert. Make sure you have reliable sources for financial news. Take a drive through the not so busy Ngong Road. But do stay away from changing your investment strategy or consult an expert before doing so. I was right! Another phenomenon that clouds our judgement in financial decisions is known as confirmation bias. This occurs when someone interprets a situation according to their own pre-existing beliefs. A classic example of this is news on social media platforms. Social media users are faced with a lot of news sources, which vary in credibility. Fake news with their catchy headlines and unproven claims can become easily viral. Readers will read these stories which align with their pre-existing beliefs, and repost or share them on their social media, which spreads this misinformation even further. Warren Buffet, a very well-known and legendary investor, put confirmation bias in a very simple way, “What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.” In the context of finance, confirmation bias can lead to poor investment decisions or choices. For example, let’s say there is an investor who has a good opinion of a company and chooses to invest in that company based on their opinion. The investor will selectively collect information, based on their opinion, to confirm that they were right in investing in that company. The company sees a fall in their stock price and yet, the investor’s bias will convince them that the drop is temporary and seek information to support their belief that the stock price will rise in the near future. And convince themselves that they are right. The problem with this is that the investor’s bias will keep convincing them that the stock price will rise and in reality, the company’s stock price may never rise. This bias is not immune to financial planners or experts, but financial planners are aware of this bias which normal investors may not be aware about. So, the tricks to breaking this spell is to seek guidance from skilled financial planners and experts and having a global view of what’s happening with your investments and listening to different points of view on your investments. In conclusion Yes, it is important to understand the mechanics of basic personal finance, but it is even more important to understand how we act, as people, in different or unpredictable situations. This pandemic is teaching us a lot about ourselves and the way we act or make decisions. The way we shake our hands, the way we work, the way we socialize is all changing and the same is likely to happen with our decision making for finance matters. We should all be cognizant of how we think and make decisions before jumping in or out investment products so consult a credible financial expert. And yes, avoid falling prey to unsound or biased advice.