“Effective financial planning is 90% mental. The other half is about money.”
— David Martin, Eltero Financial Partners
Ok. So, I might have stolen and paraphrased Yogi Berra’s famous quote about baseball being 90% mental with the other half being physical.
The math might not add up but there’s a lot more correct about this quote than incorrect.
The real magic in successful financial planning, is discovering tax and investment strategies that not just work from a financial perspective, but more importantly that work for a client on an emotional level.
What good is a plan that the client cannot or does not want to do? If a person can understand why the plan works for them and can feel driven to complete the steps to achieve their goals, they will most likely follow through on the plan.
The financial services industry has gotten lost over the years in thinking that our financial challenges can be fixed by purchasing more of the products they create. It’s a shame how many mismatched portfolios and financial plans I see.
I recently completed a course called Behavioural Finance offered by Duke University. It was a good reminder that in the world of financial planning, the path to success is littered with psychological traps—cognitive biases that can lead even the most intelligent investors astray.
Here are 3 biases that could throw a wrench in the gears of successful financial decision-making.
- Confirmation Bias: Seeing What We Want to See
The algorithms used by social media platforms (in)famously feed our confirmation bias. You can claim you don’t know how that dancing baby video ended up in your feed, but you’re not fooling anyone.
In the financial planning world, confirmation bias occurs when a person believes that a particular strategy is suitable to their situation. They only seek out information that confirms their existing beliefs about the strategy’s potential. They focus on positive news and the online experts that support their beliefs, while disregarding any negative reports or data suggesting the strategy is not optimal for them.
This selective information gathering leads them to follow the strategy despite signs that it probably doesn’t fit their long-term goals.
This can result in missed opportunities for diversification or ignoring potential risks, ultimately impacting the investor’s financial health.
2. Anchoring Bias: The First Number Wins
Go look in your cutlery drawer. Is there a Ginsu knife in there? If you have one, you might have fallen victim to anchoring bias.
Paid TV ads were famous for the line, “You would expect to pay $300 for this amazing product…”, and then tell you can get it for $29.95. They plant the seed in your brain that their product is “worth” $300 but you will get a deal if you act now.
Anchoring bias in investing can occur when an individual relies too heavily on an initial piece of information, such as a past stock price, to make subsequent investment decisions.
Consider an investor who purchases shares of a company at $100 each. This price is set as their reference point. If the stock price drops to $80, the investor might think this as a discount based on their anchored price, rather than re-evaluating the stock’s value in the context of current market conditions.
This could lead them to throw good money after bad, influenced by the initial price rather than current performance indicators. Your ability to respond to new information is hindered and you don’t adjust your strategies accordingly.
3. Herd Mentality: Following the Financial Flock
Herd mentality is making personal decisions based on the advice, sentiment, or actions of their peers, rather than their independent analysis. This is a huge problem in financial planning.
People come to see me when they are trying to overcome a challenge. It might be how to efficiently save, invest, and spend their money for retirement, or something a little more nuanced, such as effectively implementing corporate structures or rebuilding their financial foundation after divorce or the death of a spouse.
When I ask them why they’ve made certain decisions with respect to their income, taxes, or portfolio, more often than not, they said their buddy does it, or an online expert or forum said it was the best thing to do.
Not to sound like your mother, but if everyone else was jumping off a bridge, would you do it too?
The Silver Lining
There are dozens more cognitive biases. And we all have them, in one degree or another.
But our biases don’t have to dictate our financial future. By acknowledging the existence of these mental shortcuts, we can adopt strategies to counteract their effects.
Remember, the goal is not to eliminate biases but to understand and manage them, ensuring they don’t derail your financial plans. Setting specific goals, seeking diverse perspectives, and maintaining a long-term view can help you make more balanced financial decisions.
If you feel you, or someone you know, might be making risky financial decisions based on an unknown cognitive bias, please reach out to me to discuss so we can head off any potential issues that could negatively affect your financial future.
Connect with David on LinkedIn.
Disclaimer: Our content is intended to be used for informational purposes only. It is very important to do your own analysis before making any investment and tax-related decisions. You should seek independent financial advice from a financial advisor near you.
