Our brain’s pitfalls towards financial decisions

BY ANDREW STEWART

The human mind makes millions of decisions each day. If each one required a comparison of pros and cons, we would often fail to act, resulting in limited productivity. To help aid us and our brains in decision-making, we utilize mental shortcuts called heuristics. In many cases, a heuristic is a simple procedure that helps us find adequate, though often imperfect, answers to difficult questions. In some instances, the use of heuristics results in flawed judgements and interpretations and sub-optimal outcomes based on inaccurate, illogical, and irrational thinking.

Financial advisors often use heuristics in the form of rules of thumb. Some of the most common include:

• 50/30/20 Rule: allocate 50% of after-tax income to necessities, 30% to financial goals (such as debt reduction or saving), and 20% to wants
• Six-Month Emergency Fund Rule: keep enough to cover at least six months of expenses in liquid assets for emergencies
• 70% Retirement Replacement Income Rule: plan to generate at least 70% of current after-tax income in retirement to maintain your lifestyle
• 10% Retirement Savings Rule: save at least 10% of earnings towards retirement
• 4% Withdrawal Ratio: withdraw less than 4% of invested retirement assets annually to help preserve retirement savings
• Age Rule for Equities: subtract age from 120 to determine the percentage of equities that should be in an investment portfolio

The reason I am alluding to our brain’s use of heuristics is because when combined with biases, it can have devastating financial consequences. In processing information, the human brain classifies and categorizes new information and experiences to help it make sense of the world around it. It determines whether that information aligns with personal beliefs and also takes into consideration feelings about the information and any resulting decisions. Errors in inaccurately understanding reality based on stereotypes are biases.

Many factors affect biases, including an individual’s sex, gender, culture, religious and spiritual beliefs, current circumstances, learned behaviour, and the heuristics we use to make decisions. Let’s discuss some common biases that affect our decisions with financial matters.

When we make judgements and decisions based on an initial point of reference and focus on one piece of information and discount all other pieces of information it’s called anchoring and adjustment bias. For example, the cost of insurance can be a sticking point for families who feel that what they will pay exceeds the potential benefits they will receive. They fixate on the cost, rather than taking into account the benefits insurance provides.

The conservatism bias is the tendency to alter a belief insufficiently when presented with new information. People compare new information to their pre-existing knowledge and beliefs. Many times, they overlook the importance of new information, even when it is accompanied by strong evidence. Rather, they attach greater credence to their existing knowledge and beliefs. If people do choose to revise beliefs and/or act on new information, they tend to be slow to do so, which can have significant consequences.

The illusion of control is the belief that you can influence an outcome that is outside your control. The human brain prefers predictability and order to arbitrariness, so it is wired to believe that it can, given enough information, identify, predict and control events. Many individuals don’t think they need life, disability or critical illness insurance because they come from a family with longevity in their genes, eat healthy foods, exercise, and avoid smoking and drinking. They believe they have full control over their health but, of course, they are still at risk of dying, acquiring a disability or developing an illness.

People generally seek financial support in two circumstances. They decide they need to make a change and/or change is thrust upon them. We do not like change. It can be an unsettling experience filled with unknowns, discomfort, apprehension and fear. All of this can be tiring, particularly for the mind. It is no wonder that so many people favour the status quo. Only when the status quo becomes unacceptable are people truly motivated to make a change. This is as true for financial matters as it is for losing weight, stopping smoking or finding a new job.