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Cognitive biases can cause us to think and act irrationally. Not exactly good news when it comes to making smart financial decisions.
When it comes to investing, it is always best to base your decisions on cold, hard facts. Sadly, this is not always the case as our brain can get in the way.
That is because our minds are hardwired to use mental shortcuts when we are faced with complex decisions. These shortcuts are known as cognitive biases and are nature’s way of helping us make sense of the world around us.
The problem is these biases can cause us to think and act irrationally. Not exactly good news when it comes to your children making smart financial decisions.
However, knowing these biases exist is the first step to conquering them. So which ones should you be looking out for in your kids?
Here are five:
- Confirmation bias
Many of us are prone to confirmation bias. This is, when we pay close attention to evidence that supports our existing beliefs while ignoring anything that challenges or contradicts these views. Confirmation bias can make us believe an investment idea is better than it actually is.
- Herd mentality
Humans find comfort in groups. This can lead to herd mentality (sometimes known as the bandwagon effect), which is when investors follow the actions of a larger group, rather than basing decisions on their own research. For example, imagine your children’s friends are investing in a new cryptocurrency. Your child might then buy into it too as ‘everyone is doing it’ and they do not want to miss out. But there isn’t safety in numbers. Often, the herd mentality can cause your children to make financial decisions they later regret.
The anchoring bias is when people put too much weight on the first piece of information they came across when making a decision. Once that first piece of information is set, our brain adjusts based on that anchor. Unfortunately, anchoring can skew the decision-making process. Imagine, for example, you saw a shirt that costs $500, if you then see a similar shirt that costs $100 you might think the second shirt was cheap. However, if you saw a $20 shirt first and a $100 shirt second, you would be more likely to think it was expensive.
- Gambler’s fallacy
This is the belief that future probabilities are altered by past events. If someone flips a coin and it lands on heads five times in a row, the sixth flip is more likely to be tails, right? Wrong. That is because each flip is independent from the last. So, there is always an equal chance the coin lands heads down or up every time you toss.
- Endowment bias
Finally, there is the endowment bias. This is when people assign greater value to an investment they already own compared to one they do not. Therefore, letting go of it can feel like a loss even if it is the right decision to make. As a result, your children may hold on to a badly performing asset instead of selling it. This can mean they miss out on better opportunities.
If you would like to have a confidential discussion about your family wealth, speak to Affinity Private Advisors today by calling 1300 769 304, emailing firstname.lastname@example.org or filling in this online form.
The information contained in this article is current as at 28/07/2022. Any advice or information contained in this report is limited to General Advice for Wholesale clients only.
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