Why mental shortcuts could harm your financial decision-making skills

Every day you’ll take mental shortcuts, known as “heuristics”, to help you solve problems quickly. This can be incredibly useful in some circumstances and help you avoid becoming overwhelmed by decisions. Yet, when you’re making large decisions, including how to handle your finances, it could be harmful.

Heuristics are necessary for people to navigate their day. Indeed, according to a report in Harvard Business Review, the average adult makes more than 30,000 decisions every day, from what you’ll eat to what you’ll say.

Gerald Zaltman, a Harvard Business School professor, suggests that 95% of our cognition occurs in the subconscious mind. He adds this is necessary – your brain would short-circuit if it had to weigh up each decision one by one.

So, mental shortcuts are essential for functioning. However, this “autopilot mode” could lead to bias and decisions that aren’t right for you. Recognising which decisions would benefit from more careful analysis could help you seek out opportunities and identify potential risks you might have overlooked if you took a mental shortcut.

4 mental shortcuts that may affect your financial decisions

1. Anchoring effect

Anchoring effect is a cognitive bias where your view and decisions are fixed on a particular piece of information.

For example, if you read in the newspaper that a company is poised to grow and its value is above the current market valuation, you might fixate on this number. You may dismiss new information that suggests the initial figure was incorrect because you’ve anchored your view.

It’s a bias that could lead to you minimising potential risks or failing to adjust your view as circumstances change.

Anchoring can be difficult to avoid, but taking time to review new information and the reliability of sources could help identify where it may affect your decisions.

2. Herd mentality

Herd mentality can affect many areas of your life, not just your financial decisions.

The instinct that there’s safety in numbers could lead to you following the crowd even if it’s not the right option for you. You may simply believe that a large group of people can’t all be wrong, or that others have carried out research, so you can rely on their decision-making skills.

However, herd mentality overlooks the fact that a decision that may be right for one person isn’t necessarily the right option for another.

If you hear a group of your friends are investing in a particular fund that they’re excited about, you might be tempted to do the same. Yet, perhaps they’re investing with a very different time frame or are taking more risk than is appropriate for you.

Assessing financial opportunities with your circumstances in mind could help you avoid following the crowd.

3. Confirmation bias

Confirmation bias refers to the tendency to favour information that supports your beliefs and ignore the data that refutes them.

Confirmation bias can be a challenge when you’re making financial decisions because it might mean you bypass key pieces of information simply because it doesn’t support your preconceived notions. So, it could mean steps to carry out research aren’t as valuable as you might expect.

Not letting your views cloud how you view information can be challenging. Yet, taking a step back to weigh up the value of the information objectively could help you make better financial decisions.

4. Familiarity bias

You might gain some comfort from sticking to what you know. However, familiarity bias could mean you miss out on opportunities and, in some cases, might even mean you’re taking more risk.

For instance, from an investment perspective, it might mean that your portfolio is heavily invested in one geographical region or sector. While the familiar might feel “safer”, the lack of diversity in your investment could actually mean you’re taking more risk.

Similarly, many people choose to hold their money in a savings account where it could be falling in value in real terms once inflation is considered because they’re scared to invest.

According to a survey from interactive investor, 78% of UK adults don’t invest and a lack of knowledge is one of the key reasons. While investing isn’t right in all circumstances, some people may be neglecting to consider investing simply because saving is more familiar.

Working with a financial planner could help you step out of your comfort zone to seize opportunities that are right for you.

Working with a financial planner could help you view your finances from a different perspective

Looking at your finances from a different perspective could help you identify where heuristics could be affecting your decision-making skills. A tailored financial plan could help you set out a path that’s right for you, based on your goals and circumstances, and may help you reduce the effect of bias.

If you’d like to arrange a meeting to discuss how we could support your goals, please get in touch.

Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The value of your investments (and any income from them) 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.

Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.