The Role of Behavioral Finance in DecisionMaking
Understanding personal biases and cognitive processes can help you make better decisions about debt, payments, risks and investments. This is particularly important when it comes to wealth management.
Financial advisors can use behavioral finance tools to address clients’ biases and encourage them to seek diverse perspectives, set realistic goals and monitor their progress.
There has been much scientific debate over whether feelings facilitate or interfere with effective decision making. Some scholars argue that feelings are a source of unwanted bias (e.g., regret aversion bias, status quo bias, greed bias), and need to be properly regulated in decision making. Others maintain that feelings per se facilitate and enhance working memory capacity and thus promote decision-making effectiveness (Damasio, 1994).
However, it is important to differentiate between cognitive errors and emotional biases when considering the impact of feelings on decision making. Cognitive errors are primarily due to faulty reasoning and can be addressed through education and training, while emotional biases are more difficult to address because they are rooted in impulse or intuition. Moreover, it has been shown that emotion differentiation is associated with reduced levels of emotional bias. Our results support the latter view, suggesting that individual differences in how people regulate their feelings may determine their overall decision-making performance.
A heuristic is a shortcut that allows a person to engage with their environment quickly and efficiently. Heuristics are useful, but they can also lead to erroneous judgments. The availability bias, representativeness bias, and anchoring and adjustment heuristics are just a few examples of the mental shortcuts that can lead to error in decision-making.
Heuristics are often based on generalizations and rules of thumb, which are fine when they work correctly. But when they do not, they can become real pitfalls in the decision-making process.
For example, Audrey’s heuristics will likely make her think that vitamins are either toxic or harmless. This will influence her initial thought process and cause her to reject the study’s conclusions. This is due to the belief-bias effect, which states that people are more skeptical of a conclusion that seems unbelievable (Evans & Feeney, 2004).
Confirmation bias is the tendency to search for, favor and interpret information in a way that aligns with pre-existing beliefs, expectations or hypotheses. It also causes people to recall supportive information more positively and ignore contradictory evidence.
Almost everyone in a decision-making role, from the receptionist to the CEO, experiences this type of cognitive bias. It is an unavoidable fact of human life, as it is impossible to process all the information that comes at us on a daily basis in an unbiased manner.
The problem with confirmation bias is that it thwarts reliable belief formation and truth tracking. This is particularly true in emotionally charged and deeply entrenched issues. It also causes people to make the halo effect mistake, which is when one’s initial impression of someone or something influences their subsequent impressions. Examples of this are when a teacher may give students who were chosen at random more praise and attention, assuming that they are more promising than the other students.
Framing is the way options are presented to people. Israeli psychologists Amos Tversky and Daniel Kahneman were the first to systematically study and prove the influence of framing on our decision-making. Their research centered around the concept of prospect theory, which explains how people weigh gains and losses differently.
For example, if you’re selling a new hand sanitizer that kills 99% of germs, it will likely sell better if framed as a gain rather than a loss. You can apply this to any situation where you present the same information in different ways.
Tversky and Kahneman found that when people are offered two identical options—for instance, saving 200 of 600 sailing passengers on a sinking ship or letting them all die—they tend to choose the option that’s framed positively (Program A). They argue this is because the amygdala emits a Pavlovian approach-avoidance signal at the time of choice, thus biasing their choice (see figure below). Other experiments have shown that the effect disappears when choices are presented in a foreign language.