Financial planning may seem like a numbers game, but there’s more to it than just numbers and figures. Pretty much all your financial decisions are driven by emotional and cognitive biases—from the need to invest to how we invest. So, it wouldn’t be far-fetched to say that financial planning has psychological roots.
Emotional Roots of Financial Decisions
Take, for example, these scenarios:
Gold and real estate are considered ‘safe bets’ due to the emotional and cultural value attached to them.
Investment decisions are driven by goals with emotional significance, such as ‘children’s weddings,’ ‘buying a home,’ and ‘family vacations.’
Loans and debt still carry a negative connotation.
Investing in the stock market is often seen as a form of gambling.
Although these scenarios may appear to be financial decisions, they are actually deeply rooted emotional responses. These are classic examples of emotional and cognitive biases. This amalgamation of psychology and numbers is called Behavioural Finance. It encompasses your behavioural biases and the emotional responses to these biases that shape your financial decisions.
Many times, these biases can hinder sound financial decision-making. If you want to avoid making financial choices based on emotions, you need to be aware of behavioural biases and practical ways to counter them.
Cognitive Biases and How to Counter Them
Here are some behavioural cognitive biases, along with strategies to counter them:
Loss Aversion
Loss aversion suggests that the pain of losing is greater than the joy of winning. This bias is especially prevalent because emotional reactions to market changes can significantly influence decision-making.
Example: Despite sound analysis recommending a sale, you might hold onto losing investments for too long, hoping to recover your losses. Or, after a significant market downturn, you may sell your holdings out of fear—potentially during a slump—causing you to miss out on a market rebound.
How to counter the bias: View market declines as temporary setbacks rather than catastrophes. Focus on the long term and stay invested through structured investment plans such as SIPs.
Anchoring Bias
Anchoring bias occurs when decisions are based on existing knowledge or initial information.
Example: You may anchor your expectations to past returns or arbitrary benchmarks (e.g., “my brother made a 30% profit in stocks last year, so I should too”), which distorts rational planning.
How to counter the bias: Focus on your personal financial goals rather than comparative benchmarks. Financial success is subjective—what matters is achieving milestones aligned with your goals.
Herd Behaviour
When you follow the crowd instead of conducting your own research, it’s known as herding in financial markets.
Example: As a first-time investor, herd mentality may lead you to make impulsive decisions. Social pressures and market speculation might influence you to buy or sell specific stocks.
How to counter the bias: Consult a financial advisor and develop a personalised roadmap outlining your financial goals, asset allocation, and rebalancing strategy. This plan acts as a stabilising anchor during volatile periods.
Familiarity Bias
Familiarity bias occurs when you prefer familiar options over new ones. This bias arises because you feel more comfortable and secure with things, people, places, or concepts you already know.
Example: You’ve been investing solely in fixed deposits for years. Although other investments (like mutual funds) offer higher potential returns, you hesitate to explore unfamiliar options, favouring the tried-and-tested.
How to counter the bias: Take a step back and assess your portfolio to identify underperforming assets. Explore new investment opportunities and diversify your portfolio.
Mental Accounting
Mental accounting bias involves categorising and treating money differently based on its source or intended use.
Example: You may be more willing to spend lottery winnings on frivolous purchases than money earned through your job.
How to counter the bias: Treat all money with equal consideration. Avoid compartmentalising funds based on their origin—don’t view windfalls as an excuse to splurge.
Gambler’s Fallacy
Gambler’s fallacy is the mistaken belief that the likelihood of a random event is influenced by previous outcomes.
Example: A stock has been rising steadily for several days. You may assume it’s bound to fall soon, even though past performance doesn’t predict future movement.
How to counter the bias: Prioritise objective data, conduct thorough research, and seek insights from external sources. This ensures your decisions are based on logic and evidence, not emotional bias.
Investing, saving, and wealth creation are often driven by emotional responses to financial goals. Rational financial planning can be disrupted by these emotional factors. The best way to tackle cognitive and emotional biases is to start by acknowledging them. Be self-aware and critical of your biases and seek diverse perspectives. Moreover, embracing emotional intelligence practices can enhance your ability to understand and regulate emotions, ensuring they don’t cloud your decision-making process.
