Why your psychology can affect your financial decisions, and how we can help

There’s a good chance that you’ve felt as though those around you are watching your every move at some point in your life.

Perhaps this was during a work presentation, while catching up with your friends, or even when you’re having a quiet moment in a local park.

In these situations, you may become hyper-focused on how others perceive you, replaying conversations in your mind or interpreting silence as judgment.

This fascinating phenomenon is known as the “Blue Dot Theory”, and it shows how your brain is wired to detect patterns, even where none exist.

In psychology, when people are asked to identify threats or problems, they often see them even more, even when the number of issues stays the same or drops.

This kind of subconscious bias can also significantly affect how you make financial decisions.

Certain behaviours can lead you to misjudge risk, overestimate your knowledge, or follow the crowd, all of which could harm your long-term financial wellbeing.

With that in mind, continue reading to learn about five psychological biases that could affect how you manage your wealth, and how working with a financial planner could help.

1. Overconfidence bias

“Overconfidence bias” is the tendency to overestimate your own knowledge or abilities. You might notice it in your day-to-day life, perhaps believing you’re a better-than-average driver and taking unnecessary risks behind the wheel.

The same thing can happen when you invest. If you’ve made successful choices in the past, you might begin to assume you can replicate this consistently.

You may even feel confident selecting investments based on past experience, believing your judgment is better than market analysis.

This can often lead you to make bold decisions without fully considering the risks. You might believe your “wins” are due to skill, while “losses” are due to bad luck or external factors.

To avoid falling into this bias, it’s worth reflecting on any decision you make objectively. A financial planner could offer a helpful second opinion and help you distinguish between genuine insight and overconfidence.

2. Herd mentality

It’s entirely natural that you’d want to follow the crowd at times. “Herd mentality” has helped humans survive throughout history, after all.

However, this instinct can actually work against you when it comes to investing.

You might feel pressured into investing in a popular company or sector simply because others are. It might even feel like a safe move since everyone else appears to be making money.

In reality, everyone has different goals, tolerances for risk, and investment time frames. What works for your friends and family might not work for you.

A recent example of herd mentality is the dot-com bubble in the late 1990s. As internet companies rose dramatically in value, many investors jumped on the bandwagon, pushing the tech-heavy Nasdaq index in the US from under 1,000 points to over 5,000 between 1995 and 2000.

Yet, Investopedia reveals that when the bubble burst in 2000, the index fell by more than 75%, and many people around the world experienced significant losses.

Rather than following the latest trend, you might want to take a moment to examine whether an investment truly aligns with your unique circumstances. Doing so could help you make more informed choices.

3. Confirmation bias

Perhaps one of the more common cognitive behaviours, “confirmation bias” is when you make decisions based on pre-established assumptions rather than facts.

Again, it’s normal to seek out people who have like-minded views. However, when you’re investing, this behaviour could distort your strategy.

For instance, if you have a pre-established belief that a particular sector will perform well, you may gravitate towards information that confirms this.

Conversely, you might ignore evidence suggesting the sector won’t perform as well as you believe, leading you to hold onto an investment despite information suggesting it might be worth selling.

To avoid confirmation bias from clouding your investment decision-making, it’s worth examining your beliefs for ways you might be wrong, rather than ways you’re right.

Also, seeking advice contrary to your beliefs – perhaps from a financial planner – could allow you to weigh the facts more accurately.

4. Loss aversion

Another prevalent cognitive bias is “loss aversion”, when you feel the pain of loss twice as strongly as the pleasure of an equivalent gain.

For example, imagine you’re offered a guaranteed payment of £900, or a 90% chance of winning £1,000.

You may feel inclined to avoid any risk at all and take the £900, even though the odds of winning the larger sum are in your favour.

Similarly, if you’re given the choice between a 100% loss of £900, or a 90% chance to lose £1,000, you may prefer the second option, taking a “riskier” decision in hopes of avoiding a loss.

When you invest, loss aversion could lead to an inconsistent strategy as you subconsciously avoid the stress of loss, even if it would lead to an opportunity for gains.

In this instance, you may become too risk-averse and fail to achieve growth that helps you reach your long-term goals.

To avoid the effects of loss aversion, you may want to avoid becoming too emotionally involved with your investments and remember that many risks are outside your control.

A financial planner could help you assess your tolerance for risk and design a portfolio accordingly.

5. Recency bias

If you feel the tendency to make crucial decisions based on recent events, especially negative ones, then you may be experiencing “recency bias”.

At the same time, you might consider less recent events unimportant or forget they happened altogether.

For instance, you may see how well tech companies have performed in recent months and decide to invest heavily in the sector.

You might assume this upward trend will continue based on recent information, when in reality, the overall value of your portfolio could decline if the sector experiences volatility.

As such, limiting your exposure to financial news might be prudent to avoid recency bias from clouding your judgment.

“Noise” from media outlets is designed to capture your attention, so it tends to focus on the negatives. This might simply fuel your concerns and mean you focus on more recent information.

Alternatively, a financial planner could allow you to understand events in the wider market and help you build a diversified portfolio.

Get in touch

We can help you make sensible financial decisions in line with your goals.

Please email contact@caliberfm.co.uk or call 01525 375286 to speak to one of our team today.

Please note

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

All information is correct at the time of writing and is subject to change in the future.

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.