Close Brothers Asset Management
How do our ingrained biases affect our purchasing decisions and investment strategies? When we make purchases, and when we invest, we like to think that our decisions are based on logical rationale. But what if we’re not really being that logical at all – what if we’re actually being swayed by unconscious behavioural biases?
In this Q&A, Richard Shotton unpacks some common behavioural biases and explores their implications for how we spend and save money.
Q) Why are we more tempted to splash out when we pay with cards rather than cash?
A) There’s a concept, called the “pain of paying”, which suggests that people’s reaction to a price is not just based on the actual amount they’re spending, but the level of pain it generates. And the more distant people feel from the act of handing over hard-earned cash, the less price-sensitive they become. A study done by Professor Duncan Simester, from the Massachusetts Institute of Technology’s Sloan School of Management Science, found that, on average, people bid almost twice as much for basketball tickets when they paid with cards rather than cash. When it comes to managing our own finances, we need to be careful about using cards and moving purchases onto subscription. When we do that, we’re hiding the pain of paying from ourselves, and may end up spending more than we want to.
Q) How does price relativity tend to affect our purchasing decisions?
A) Psychologists have found that people don’t treat money in an absolute sense. They often treat it relatively. So, if they are buying a house, paying £1,500 in surveyor’s fees feels a small proportion of their overall spend. As a result, they won’t necessarily go to another surveyor to see if they can get a better deal.
Q)What is social proof and how does it influence our investment and purchasing decisions?
A) The principle of social proof is that, when we make decisions, we don’t do it as discrete individuals. Instead, we look round to see what others are doing. If a course of behaviour looks like it’s commonplace, it becomes more appealing, and we are therefore more likely to follow that behaviour. So, if lots of people are buying a certain washing machine or a certain car, for instance, we believe that washing machine or car is unlikely to be awful. (And we would probably be right.) Nevertheless, social proof raises a red flag for investors. If we are attracted to certain assets because of their popularity, rather than their inherent attributes, there is a danger that we could get sucked into bubbles and fads.
Q)What about the concept of scarcity – how does that influence us?
A) Evidence suggests we value things more if they’re scarce or likely to be taken away from us. So, there’s a danger that if we are told that certain products are in short supply, or put under time pressure to make a decision, we might buy things we don’t need, or overestimate their value. This principle can apply to financial investments, as well as other types of products.
Q) How can expectancy theory influence our views of what we spend money on?
A) Expectancy theory is the idea that what we experience is partly what we expect to experience. A famous study by Baba Shiv, Professor of Marketing at Stanford Graduate School of Business, involved people being told they were tasting two different wines – one from a bottle labelled $5 (its real price) and the other from a bottle labelled $45. In fact, both bottles contained the same wine, but people gave a higher rating to the wine from the bottle with the fake label because they expected it to taste better. So, if you think a wine is going to be amazing and then you try it, it’s more likely that you will consider it amazing. Similarly, people’s expectations can stop them gaining enjoyment from lower-priced items.
Q) How can confirmation bias lead us astray when it comes to making investment and purchasing decisions?
A) Confirmation bias links to expectancy theory. It’s the idea that people don’t interpret facts neutrally – they seek out information that supports their existing opinions. This can be a danger when they come to investsince, if they have a pet theory, their natural tendency will be to seek out information that supports their hypothesis. To avoid making expensive mistakes, they should look to override that natural tendency and try to prove their pet theory wrong.
Q) Alongside confirmation bias, isn’t overconfidence also a major risk for investors?
A) There’s a lot of evidence that we are overconfident in many areas of our lives, whether it’s our intelligence, our grammar, our jokes or our driving ability. Study after study shows that most people rate their abilities as above average, which can’t actually be correct. The fact that that overconfidence exists is reasonably well-proven. There’s more speculation around why it exists. It might be the case that evolution rewards what is not necessarily the supposed right answer, but what works best in practice. From an evolutionary perspective, it’s better to try to face challenges, rather than to give up and not bother. For investors, the risk is that if we start thinking that we are better than average, we might take risky approaches that are unwise. If you acknowledge that you don’t know for sure, you might spend more time thinking about how you spread your risk to minimise potential downsides. That’s probably healthier financial behaviour.
Q) What is the psychological impact of ‘sunk costs’ on investment strategies?
A) People are influenced by the scale of their investment in the past. This can mean they don’t cut their losses as often as they should. Also, by focusing on sunk costs, they don’t think about the potential for future gains. The fact they happen to be already invested in a particular share should be neither here nor there. They should be thinking about what choice – hold or sell – is going to generate the most happiness in future.
Q) Talking of happiness, how can we use our spending decisions to maximise our own happiness and that of those we love?
A) Most people think that happiness comes from making more and more purchases for ourselves. Actually, there’s strong evidence that we’ll generate more happiness per pound spent, if we spend it on others. Also, experiences tend to be better at generating happiness than physical purchases. It’s not about behaving like saints – being generous to others brings big benefits to ourselves. It’s enlightened self-interest.