Making decisions - Are you rational or normal?

Making decisions – Are you rational or normal?

After having many discussions this week with people in my age group about the Covid vaccine’s available to us, it got me thinking about the cognitive and behavioural biases that we all have – and how they affect our overall decision making. Whilst we may think of ourselves as rational, in the complex world of information we live in we are much more likely to rely and use mental shortcuts to make decisions.

Of particular interest to me is how these affect the financial and investment choices we make.

Having a solid self-awareness of your own biases can assist you to make better decisions – and from an investing perspective this is critical to ensuring you reach your long term financial goals. Below we will outline a few common biases and give some examples of how they play out in an investment sense.
We would also love to hear of any biases you may have identified in yourself after reading this article!

 

Confirmation Bias

Investors will more often notice and look for information and evidence that confirms their existing beliefs, at the expense of evidence that challenges or goes against those beliefs. Human beings tend to avoid the discomfort when information conflicts with current beliefs or perceptions.

This plays out in the investment world in that you may ignore information conflicts with your previously held belief – which if not ignored may present an opportunity or help you prevent losses.

 

Anchoring bias

This is the tendency to rely to heavily (or anchor to) a piece of historical information when making an investment decision. The brain then makes adjustments based on this anchor, which can adversely affect your ability to make sound decisions.

The most common example of this is anchoring to a past share price, irrespective of the companies future outlook.

 

Narrative Bias

This is the tendency to interpret information as part of a larger narrative or story, sometimes at the expense of facts.

What we have seen a lot in the last 12 months is investors abandoning fundamentals for a great story. While these stories can be very compelling, we cannot be blinded by this and need to consider the whole picture of an investment.

 

Overconfidence Bias

The Dunning-Kruger effect – when people overestimate their own abilities, believing they are smarter or more informed then they really are.

Investors with this bias tend to underestimate the risks/overestimate the returns of a particular investment. They also tend to excessively trade, thinking that they have better information than the broader market.