Subconscious bias can affect your financial decisions. They might mean you make decisions that aren’t right for you. Setting a goal could help reduce the effect bias has. Read on to discover three reasons why.
Cognitive bias is an error in cognition that can happen if your personal beliefs or experiences affect a decision you’re making. So, you might act based on an emotion rather than evidence. In some ways, cognitive bias is useful – it helps you make decisions quickly.
However, there are times when bias is potentially harmful, including when you’re making financial decisions.
Loss aversion is a common type of financial bias that might happen when you’re investing. Loss aversion is a tendency to avoid losses over achieving equivalent gains. The theory suggests that people feel more pain from losses than they feel pleasure from gains.
From an investment perspective, loss aversion could mean you’d prefer to hold your money in cash, even though it could be losing value in real terms once you consider inflation. Or that you choose low-risk investments even when taking greater risks would align with your goals and circumstances.
In these cases, loss aversion could mean missing out on an opportunity to grow your wealth because you’re worried about potential losses.
There are many other types of financial bias, and setting out your goals could help you manage them. Here are three insightful reasons why.
1. A goal could help you understand why certain decisions are right for you
A clearly defined goal can give you a sense of direction and an understanding of why you’re making certain financial decisions.
Having a long-term vision could mean you’re less likely to have a knee-jerk reaction due to emotions or events that are outside of your control. For example, if market volatility means the value of your investments falls, knowing that you’ve invested with a long-term view could help you stick to your plan, even if you’re nervous.
Setting out goals and understanding what’s realistic might remove some other forms of bias too.
Overconfidence bias involves overestimating your skill or knowledge when investing. It could mean you overlook relevant information or feedback because you believe you’re correct. In some cases, investors take more risk than is appropriate for them because they believe they’ll be able to secure higher returns by doing so.
A goal could temper some of the impulsiveness you might experience if you’re overconfident. If you’ve calculated you can secure your goals by achieving average annual investment returns of 4%, you might be less likely to chase potentially higher returns that could result in losses.
2. Setting goals could mean you recognise when emotions are affecting your decisions
Emotions are one of the reasons why people might make financial decisions that aren’t right for them. From feeling fearful during market volatility to being excited when a new opportunity comes along. Emotions might mean you don’t take the time to fully assess your options before acting.
Setting a goal can’t remove your emotions, but it might mean you’re more likely to realise when they could be clouding your judgment.
Let’s say you’re talking to a group of friends who are excitedly talking about an investment opportunity that they say will deliver high returns. It can be easy to be swept up in the conversation and invest without carrying out additional research to see if it’s right for you.
However, if you’ve set an investment goal and know what steps you need to take to reach it, you might be less likely to be side-tracked by emotional decisions.
3. A goal could help you form positive money habits
Working towards large goals often requires consistent and repetitive actions. You might regularly contribute to a savings account, pension, or Stocks and Shares ISA.
Taking consistent actions could help you form positive money habits that mean you’re less likely to stray from your financial plan when emotions or other influences occur.
Do you want help setting your financial goals?
If you’d like help setting financial goals and understanding the steps you could take to achieve them, please get in touch. Having an outside perspective looking at your finances could also highlight where financial bias might affect your decisions.
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.