7 fascinating cognitive biases that could negatively affect your wealth

You might consider yourself to be financially savvy, but did you know that humans have a number of cognitive biases that can sometimes sabotage even your best financial intentions?

Chances are you won’t notice these biases affecting your financial decision-making at the moment, but by understanding them better, you might be able to spot them in action. Even better, you’ll be able to override them so that you can make more sensible financial decisions.

Read on to discover seven common cognitive biases that could be holding you back from achieving your goals.

1. Loss aversion

Research shows that you usually feel the pain of a loss more acutely than the pleasure of a gain. This means that you’re more likely to take action to avoid loss than you are to pursue something you want to gain.

This can hamper your wealth accumulation over time because you could be tempted to keep your wealth in low-risk investments or even cash because it feels safer than a high-risk investment. While everyone will have their own personal tolerance for risk, opting solely for low-risk options could mean that you achieve much lower returns. By extension, you might not hit the goals you have set for the future.

Balancing risk and reward can be complex but being aware of this cognitive bias could help you to take a more objective approach to risk.

2.  Confirmation bias

Confirmation bias is so named because it’s all about looking for confirmation of something that you already believe. You may believe that supporting information is more credible than data that contradicts your belief, or in some cases you might entirely disregard evidence that opposes your view.

This can lead to a subjective understanding of a stock or index and whether it is the right investment for you, potentially hindering your returns in the long run.

3. Herd mentality or herding bias

This is the compulsion to do exactly as other people are doing because humans are hard-wired to want to fit in with a crowd.

But as you probably already know, everyone’s circumstances and goals are likely to be slightly different, so just because a course of action is right for your friend or colleague doesn’t mean it will be suitable for you.

Herd mentality can lead to you making rash decisions about your portfolio that aren’t aligned with your own goals. To avoid this, make sure you challenge yourself over the reason why you want to take a decision to ensure you’re doing the right thing for you and for the right reasons.  

4.  Recency bias

Also known as “availability bias”, this is the tendency to make decisions based on recent events, particularly negative ones, while considering less recent events to be irrelevant or even forgetting that they happened.  

If you suffer a drop in portfolio value as a result of stock market volatility, you might be tempted to change the balance of your portfolio or feel spooked into taking your wealth out of the stock market entirely. However, by doing so you are forgetting to consider the returns you may have gained on your portfolio in the years beforehand.

Knee-jerk reactions or emotional decisions like this can cause your portfolio to grow more slowly than following the key principles of investing.

5.  Fluency bias

Humans are naturally drawn to ideas and information that we can process easily. This means that things we can pronounce more fluently appear to have a higher value.

When it comes to investing, this bias extends to the names of stocks and shares. Researchers have found that shares with easily pronounceable names tended to outperform harder-to-pronounce stocks, possibly because investors perceive those easy-to-pronounce shares as more valuable.

6. Familiarity bias

This bias is about habits. It’s the belief that behaviour or actions that brought about a successful outcome in the past can be applied to new situations with the same level of success.

Of course, when it comes to managing your money, this isn’t always the case. Past performance is not an indicator of future performance, particularly on the stock market. So be careful not to be drawn to certain investments purely because they performed well previously.

Consult with your planner so that you can choose a portfolio of investments that is most likely to meet your needs now and in the future.

7.  Hindsight bias

You might have heard the phrase “hindsight is 20/20”, but this certainly isn’t the case with hindsight bias.

In reality, hindsight bias is a misconception that has you believing a past event was predictable and obvious. This can lead to misplaced confidence because you might believe that you can now predict similar events in the future based on what happened in the lead-up to the most recent event.

In reality, it is almost impossible to know what will happen in the markets in the future because past performance is no guarantee of future results.

Get in touch

If you’d like to learn more about how your own cognitive biases could be holding you back from growing your wealth, and how to overcome this, we can help. Email theteam@fortitudefp.co.uk or call us on 01327 354321.

Please note

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.