In contrast to classical models of economics, which assume consumers to be rational financial decision-makers, behavioural economics uses insights from psychology and sociology to create a much more realistic picture of the factors affecting our behaviour in financial matters.

Behavioural economists draw on the long list of “heuristics”. Heuristics are mental shortcuts that can facilitate problem-solving and probability judgments. These strategies are often generalisations, rules of thumb or biases in how we think. They can be effective for making immediate judgments. However, they often result in irrational or inaccurate conclusions and have been shown to undermine our financial decision-making, especially concerning events which are in the future.

Loss aversion

Loss aversion is a cognitive bias that suggests the pain of losing is psychologically twice as powerful as the pleasure of gaining. In other words, the pain felt from losing money or seeing investments fall in value feels worse than an equivalent gain in value.

ASIC Report 2301 listed more than 30 of these biases that were thought particularly relevant to financial decision-making. However, for our purposes, the work of Furnham2 in distilling them down to the ‘7 Deadly Sins of Investing’ is a more practical demonstration.

The Seven Deadly Sins of Investing

1. Confirmation bias

We only look for information and news in favour of our ideas.

Results in: Poor decision-making due to incomplete information.

2. Optimism bias

We believe we are better and more capable than we actually are and that misfortune is more likely to befall others.

Results in: Taking on riskier positions than we should, including not taking out insurance.

3. Illusion of control 

We overestimate our control over our economic affairs, thinking we can influence the outcome.

Results in: Overactive trading and assuming we can replicate success easily.

4. Overconfidence in prediction     

We believe our view of the future is the best one.

Results in: Take a more concentrated position based on pessimism or optimism.

5. Risk and regret aversion 

Either being too cautious to invest or not wanting to get out (sunk cost fallacy).

Results in: Missed opportunities and being locked into bad investments.

6. Group think

We respond to conformist pressure to think like others.

Results in: Choosing poor investments or ones which don’t align with risk tolerance and getting into opportunities too late.

7. Memory distortion

Our memories aren’t accurate records of events. Instead, memories are reconstructed in many different ways after events happen based on certain biases, which means they can be distorted.

Results in: Repeating investment ‘mistakes’.

Negative money attitudes combined with our tendency to succumb to cognitive biases when making decisions can place enormous obstacles in the way of us achieving our career, relationship and lifestyle goals – sabotaging our happiness.

Financial Advisers are ideally placed to help their clients achieve more positive relationships with money, not by helping them acquire more of it (although that is usually an outcome), but by fundamentally reshaping their money attitudes and behaviours, and giving them a framework within which they can make better financial decisions. Further emotional benefits also accrue when the advice proves itself, reinforcing a sense of achievement and progress towards goals.

If you’re an adviser and would like to explore ways to help coach clients better to improve their relationship with money, you can download Milford and XY Adviser’s Financial Advice Reimagined whitepaper right here.