This blog offers an invitation to begin to consider how mental biases might impact on how we think about and use money. I have chosen loss aversion, the endowment effect, and the bandwagon effect. There are others which I will return to in future posts.
Let’s start with loss aversion, which is related to negativity bias. The evidence points to the fact that humans (in general) are around five times more sensitive to a negative event or comment than a positive one. Ponder that for a few seconds, that means if you are a manager giving feedback then any area of improvement should be accompanied by five areas in which the person is succeeding. And if you are wondering why you bridle so frequently at even the mildest criticism then don’t worry too much – you are experiencing an almost universal response.
In money terms this helps explain the reluctance one often encounters when discussing investing in equities. These are perceived as “risky” and negativity bias leads to many people putting money in savings accounts receiving low rates of interest as opposed to stock markets. Of course, the perception of risk is magnified, perhaps even created, by the news media, where the emphasis on the drama of stock falls can create an impression of uncertainty. A more balanced view of risk would consider the long term patterns of share prices as well as the risk inflation presents to savings.
Another common bias is the endowment effect. This is the tendency to value what we own more highly than the market. Examples include house prices, where a homeowner has a view on what their asset is worth, and they will not sell for less. This is why Economists describe house prices as being “sticky downwards”. It also helps explain why some people might hold on to shares they have emotional attachment to (perhaps a gift) even when the market reality might be to sell.
The third bias is the bandwagon effect. This is the bias we have towards copying others. As humans we are hard wired for group acceptance and therefore will often mimic common behaviour, particularly if that behaviour is being exhibited by someone we see as a leader. Marketing professionals know this only too well and it is probably the main reason for product placement where celebrities are often branded from head to toe. It also helps explain some of the behaviour around popular “investment” strategies such as cryptocurrency. If friends, family members, the financial press and social media are endlessly discussing crypto then there is real pressure to join the group. The combination of fitting in and fear of missing out on gains is just too alluring.
Challenging such deep seated biases is not easy, but a starting position is acceptance. That is recognise they exist and that most likely you exhibit (at least some of) these tendencies. This opens a space between unconscious and conscious action. You might then seek out data which help you make informed choice. Perhaps you might even work with a money coach to broaden and deepen your financial knowledge and develop positive money habits.