As an Accredited Behavioral Finance Professional (ABFP) my goal is to help individuals connect their financial objectives with their personal behaviors and motivations. When it comes to finances, many times, emotions are involved. Emotions are an integral part in all forms of decision making, but if they are not moderated the correct way, emotions can lead to faulty choices.
As individuals, we cannot process all the information available to us for a few reasons, such as limited attention, information, and processing capacity. As a result, we use shortcuts called heuristics. These are decision rules that utilize a subset of the information set and that sometimes lead to biases. In most cases, we use heuristics without even realizing it.
The following are a few common heuristics:
Familiarity
People are comfortable with things they know. They avoid investigating other options and tend to stick with what they have. This leads to people avoiding other actions even when it could be worthwhile.
Diversification
People tend to choose a little bit of everything when choices are not mutually exclusive. According to research, people prefer variety, future preferences have some uncertainty, and it saves time because your choice is made simpler.
Status Quo Bias
This heuristic/bias goes along with the idea of comfort seeking. People have a preference for the current state of things and are resistant of change. They fear the chance of regret if active steps are undertaken.
Availability
Leads one to believe that certain events are more likely to happen because they are called to mind easily.
Representativeness
The tendency to link the probability of one event based on how much it resembles another event. For example, you believe that someone who has glasses is more likely to be nerdy.
Anchoring
The tendency to adhere to one’s beliefs longer than one should. If you asked someone to estimate the value of object B knowing the value of a similar object A, they would use object A as a starting point. This can be explained by uncertainty of the true value.
How it relates to Financial Planning?
We use heuristics every day without even realizing it. In many ways they are helpful, allowing us to process information more efficiently. However, they can also lead to biases and errors in judgement. It is important to think about which heuristics you utilize the most. How are they affecting your judgement and decision making? The first step the avoiding the heuristics that cause inaccurate judgements is awareness.
When it comes to financial planning whether you are saving for retirement, college education, a home purchase, or other, each individual has to make certain decisions. It is important that these decisions are thought out and involve unbiased judgements. Moderating heuristics, which lead to biases, can aid in making better decisions for one’s financial future.