It’s human nature, that when making decisions, we quite often believe or trust our memory of past experiences, rather than the more obvious facts in front of us. We also quite often use the representative heuristic (bias) when making judgements about the probability of an event occurring in the future. Heuristics could be termed as “judgemental shortcuts” or general “rules of thumb” to enable decisions be made a little easier and quicker. But, not necessarily or normally better!!!
In an extract taken from Thaler and Sunsteins excellent book on behavioural biases “Nudge”, they explain how biases can creep in when similarity and frequency diverge. In one such example, a demonstration involving a woman named Linda, subjects were given the following information “Linda is 31-years old, single, outspoken and very bright. She majored in philosophy and as a student was deeply concerned with social injustice and participated in antinuclear demonstrations. People were then asked to rank, in order of probability the more likely of two possible careers for Linda. The two crucial answers were “bank teller” or “bank teller & active in the female movement”. Before you look at the outcome of the result, what do you think?
Unbelievably, almost 85% of respondents said that Linda was much more likely to be a bank teller and active in the feminist movement and less likely to be just a bank teller. This is of course an obvious but very clear mistake. It is simply not logically possible for any two events to be more likely than one of them alone. It just has to be the case that Linda is more likely a bank teller than a feminist bank teller because all feminist bank tellers are, well you’ve guessed it – bank tellers.
In general day to day life, reliance on this heuristic may not prove in any way costly. In finance however, this use of assumptions can be extremely dangerous when investors extrapolate past outcomes, or worse still – misrepresented past outcomes and draw excessively large inferences from too small a data pool to make decisions about their future finances rather than cold, hard, current facts. People also have a subconscious tendency to place too high a value in assuming what has happened in the past as being representative of what’s likely to happen in the future and decisions motivated by this representative bias can quite often prove costly.
It’s human nature that conditions us to think that a 6 foot 7 inch African American is more likely to be a professional basketball player than anything else, even though in fact it’s actually much more likely to be that anything else. If we’re even slightly prone to thinking that everyone who wears glasses is nerdy, or blondes aren’t really that bright, then maybe we need to seriously rethink our thinking.
This representative bias is of course well known and understood by large companies and institutions and often used by their marketing departments to influence our decision making. If we’re making decisions based on this type of thinking, this may well lead us to disregard important information that is actually extremely relevant to our judgement.
When making financial decisions, we should at least be cognisant that behavioural biases are at play. These “Rules of Thumb” which we rely on when making important decisions about our financial futures can literally be wide of the mark. I know someone who once worked in a bank for over 20 years and in all that time assumed the term “safe as houses” as meaning (representative) that property values were more or less guaranteed not to fall!!!
At Lifestyle Financial Planners, we understand that each client is individual, has their own thought processes and mix of behavioural biases and therefore reacts differently to movements in financial markets. A certified Financial Planner should be able to manage client’s differing emotions effectively by avoiding assumptions and focusing more on informed facts and long-term financial planning logic.
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Paul is the Managing Director of Lifestyle Financial Planners, has been in business since 1985 and offers specialist, tax efficient wealth management, retirement and estate planning solutions to our customers. Paul is a Certified Financial Planner and holds a Masters Degree from UCD in Financial Services and Risk Management.
Tel; 096-75951 Mob: 086-8053755, Email: firstname.lastname@example.org web: www.lifestylefinancialplanners.ie
Waiver: The information contained in this article is for general information only and cannot be relied upon as the basis for any form of agreement or advice. The author recommends that you seek independent tax, legal or financial advice relevant to your own particular circumstances.
Published May 22nd, 2017