Posted: 30/07/20 by Fortitude Financial Planning
If you’ve ever had a big box of doughnuts delivered to the office, you’ll know that the next few minutes will speak volumes about character – your own and that of your colleagues.
Some people dive straight in, any old flavour will do, but others come over all picky and won’t try the custard one because ‘they probably won’t like it’. You might steer clear of the chocolate glaze because the last time you tried it you felt queasy, but you need to reach a decision, and you need to do it before you miss the opportunity to get a doughnut at all.
Doughnuts or otherwise, the decisions we make in life use quickly accessible input drawn from experience, recent memory and hearsay, otherwise we’d never get anything done. But they’re not without danger – shortcuts, by definition, are incomplete and incomplete pictures are bad news when it comes to financial decisions.
Heuristics – why they’re good…
These mental shortcuts – ‘heuristics’ allow us to make a judgement, reach a decision or solve a problem using as little time and effort as possible. There’s nothing wrong with that in theory – if we had to map out the pros and cons of every choice we ever face, we’d grind to a halt.
Your day is full of decisions, even if you don’t realise it. Whether to get up or hit the snooze button, what to have for breakfast, what to wear, tea or coffee? Without an efficient way of taking your reasoning from point A to point B there really wouldn’t be enough hours in the day. In that sense heuristics provide templates that you can shape to the situation in hand.
They’re not blind guesses – if human evolution had taken the ‘it’s probably fine’ approach to whatever new dish might be on the menu, we’d have stopped evolving abruptly. They’re more accurately viewed as educated guesses, based on experience, available evidence and received wisdom.
… and why they’re bad
The problem is that the very purpose of heuristics, to bypass detail, to simplify information, means that they give us a skewed picture. That can lead to cognitive biases, locking us into habits and behaviours, a kind of mental shorthand, and that’s where it gets tricky.
In the 1970s, psychologists Amos Tversky and Daniel Kahneman set out three types of heuristic – ‘availability’ ‘representativeness’ and ‘affect’. The first is all about using the most readily available examples you can think of, to inform what you do next… in other words you make a decision on what springs to mind. It’s easy to see how a run of negative headlines could make you overcautious, or how an expanding bubble might seem like a more reliable investment than it really is.
The ‘representativeness’ heuristic allows us to make a best guess about the character of a person or the nature of a situation based on precedent. For example, if you didn’t go to a cocktail party because you’ve been to a couple before and they were full of people talking about house prices and school catchment areas, well, maybe you were right, but you don’t know for sure.
Then there’s the ‘affect’ heuristic, which is perhaps the most alarming of all. This is a direct correlation between the decisions you make and the emotions you happen to be feeling when you make them. We all know that it can be a wise move to count to ten before hitting ‘reply all’ on that email, but people genuinely weigh the benefits and risks of decisions differently according to their mood.
Those three heuristic types show that taking mental shortcuts can lead to snap judgements, assumptions and decisions based on emotion. As intelligent investors, we’re all able to spot these characteristics a mile off – in other people. The problem is we’re not so good at spotting them in ourselves. Here, we’re getting into the realm of behavioural bias.
Biased? Well, you would say that…
Bias can be a bit of a dirty word. It sits dangerously close to ‘bigotry’ or ‘prejudice’ but like it or not, as humans we all display a wide range of behavioural biases. The exact number of discrete biases differs between studies, but we can reliably say it’s in double figures.
From an evolutionary point of view, they help us to filter out the unnecessary detail and concentrate on what really matters. But in modern life, especially in finance where detail really matters, they can be unhelpful. Heuristics, those mental shortcuts, feed directly into biases, for example, it’s easy to see how the ‘availability’ heuristic can drive what’s known as ‘familiarity bias’, the likelihood of investing in names and regions that you know because, well, you know them. It can also lead to confirmation bias, the tendency to place more trust in evidence that backs up your existing hunches than anything that contradicts them.
They hamper ‘fluid intelligence’ closing you off to new ways of thinking. The representation heuristic could easily see you ploughing the same old furrow forever. It may always have worked, it may continue to work, but you could be shutting yourself off from worlds of opportunity.
The power of ongoing engagement
As you know, great financial planning starts with a frank, open conversation. We ask you lots of questions about what you want to get out of investing, we encourage you to ask questions of your own and we listen to what you tell us. For your part, you bring the vision, the goals and the picture of the future as you want it to be, while we bring the expertise, the experience and the professional skills.
That’s what you’d expect, it’s our role to help you turn your plans into reality, we know what we’re doing, and you can trust us to do it. But as you progress, we’ll meet for regular reviews and it’s so important that they don’t become a formality, or an exercise in just keeping the wheel spinning.
Reviews are about understanding what’s changed – in the markets, in the world, in your own life and in your ambitions. It’s a chance for you to give us new information that might be vitally important (even if you don’t realise it) and an opportunity for us to suggest new ways of doing things from here on in. There’s an oft-visited sentiment that the most expensive words in business are “We’ve always done it this way”, but it’s true of your financial planning too.
Sometimes you may feel our ideas, or your progress, run counter to established ways of thinking, but that’s exactly when it’s time to scan for bias, to eschew the short-cuts and take the long way round. A preconceived idea is only as good as the last time it worked – next time may very well be different.
Getting the future right
Remember, the decisions you make now will affect your future and that in itself is cause to weigh them carefully. But also remember that investing is a long-term pursuit – there’s no need to make snap decisions or close off avenues of enquiry. We’re not looking to get from A to B quickly, we’re looking to do it safely and securely. Let’s continue to engage, to listen, to ask questions of one another and explore newer, better ways of doing things. Let’s approach each review in a spirit of openness, curiosity and collaboration.
What you tell us offers valuable insight to where you are now and how we’ll get you to where you need to be. What we tell you in return will always be open, honest and centred on your best interests, and we’ll bring the one thing you can’t bring to your own financial picture – true objectivity.
If every review is a brand new conversation that leaves no stone unturned, no question unasked, no heuristic unchallenged, then your financial plan will continue to be sound today and tomorrow, and the only holes will be in your doughnuts.