“History never repeats itself;
man, always does.” – Voltaire

In the complex world of financial decision-making, our choices are influenced by psychological biases that can lead to less-than-optimal outcomes. Anchoring, mental accounting, recency bias, and loss aversion are four such cognitive and emotional tendencies that affect how we manage our finances. These biases shape our perceptions and decisions in ways that might not always align with our best interests. Understanding how these mental shortcuts influence our decisions is crucial. We can gain insight by examining these biases and developing strategies to counteract their effects, leading to better financial decisions.

Anchoring

Anchoring bias occurs when one relies on pre-existing information to inform future decisions. Humans tend to make decisions based on the first piece of information they see, even if that information is outdated or irrelevant. Fixating on a specific piece of information can create a mental anchor, hindering one from making informed rational decisions.

It is easy to understand this concept in the context of residential real estate. In recent years, technology has made real estate information more easily and quickly accessible. The availability of this information has created the prevalence of anchoring on a specific price for many buyers and sellers. For a homebuyer, the initial asking price might be an anchor and cause someone to overpay even if the home is overpriced to the local market. The homebuyer might feel they are getting a bargain because the final purchase price is below the initial asking price. Conversely, a seller might believe the property value of their home to be higher than what is realistic to their local real estate market. Both overpaying for a property and having unrealistic expectations of the market price could place one in a detrimental financial position.

In 2020, the two most googled financial planning questions were “When can I retire?” and “How much do I need to retire?”¹ If one anchors solely on a specific retirement age or targeted retirement dollar amount other important considerations will likely be overlooked.

Choosing the retirement age of 65 based solely on the fact that this is the age when a person can start receiving Medicare is an example of mental anchoring. While the Medicare age of 65 is relevant, there are many other questions that should be answered before making decisions about your retirement timeline. Similarly, setting an arbitrary dollar amount with which to retire with the presumption that it will be sufficient is short-sighted.

Some questions that should be answered in planning retirement include how to invest your savings, how to replace current income, how much to plan for healthcare costs, and how to maintain your desired standard of living. Anchoring to a specific age or dollar amount could increase the possibility of running out of money in retirement or possibly working longer than needed.

Mental Accounting

Mental accounting is the tendency to treat resources differently depending on how they were received or intended to be used. We often compartmentalize money into different mental buckets and look at money’s utility differently based on its source. Consider the example of a tax refund, inheritance, or other windfall. Due to the creation of these mental buckets, we may treat the way we invest, spend, or save those funds differently without considering where they fit within our long-term plan.

A common windfall for many people is a tax refund. According to the National Retail Federation Annual Tax Returns Survey, 58% of people in the United States expect a tax refund in 2024. ?”² Many view this tax refund as a bonus instead of actual income that was withheld throughout the previous year. Of those who anticipate a refund in 2024, 64% will use the funds on everyday expenses or to pay down debt. The desire to create this tax refund windfall may cause people to lower their standards of living throughout the year due to unnecessary excess withholding. It may be satisfying to get a large sum of money in the spring by offering the IRS a tax-free loan. But it may be even more satisfying to have immediate access to those funds throughout the year.

Another example of a sudden windfall is compensation in the form of stock from your employer that appreciates quickly due to that company’s success. This rapid accumulation in value, while positive, can create unforeseen issues such as portfolio concentration risk, future tax issues, and missing out on funding an important financial objective (such as retiring early).

Rather than arbitrarily assigning mental buckets to sources of money, consider those funds within the context of both your short and long-term financial goals.³

Recency Bias

Recency bias occurs when people place excessive emphasis on recent events and assumes those events will occur again. This bias frequently leads people to be swayed by the fear or euphoria of the recent past. Humans are naturally wired for recency bias. Our brains process events from recent memory faster; it is a survival instinct.

For example, assume you are vacationing at the beach. You arrive and see news of a shark attack in another part of the country. Even though the likelihood of a shark attack is very small, you decide not to go swimming. Your decision was shaped by the recent news story, even though the basis for that decision may not have been rational.

Recency bias is a constant influence in financial decisions, and not limited to investing in the financial markets. Recency bias can alter our planning for short-term and long-term goals, budgeting and spending, and gifting. It is always prudent to consider multiple factors in your financial decision-making process.

Loss Aversion

Loss aversion is a phenomenon where the distress caused by losing is experienced more intensely than the pleasure derived from gaining. In fact, Daniel Kahneman and Amos Tversky, in their 1979 paper “Prospect Theory: An Analysis of Decision under Risk,” theorized that the pain of losing is psychologically twice as powerful as the pleasure of gaining. This tendency to avoid risk can lead to missed opportunities for growth and more importantly to the inability to accomplish one’s financial goals.

Investing in the financial markets involves risk, and many people assume loss aversion is contained to investing in the markets. From a financial planning perspective, market risk is often not the primary risk. A more critical risk is the possibility of running out of money in retirement due to improper asset allocation and lack of planning during your earning years. Unnecessarily large cash holdings can cause the loss of purchasing power over time due to inflation and further cause investors to miss out on greater investment returns from a properly allocated portfolio based on their risk tolerance.

Conclusion

Increased awareness of our own biases and their potential impact, comprehensive wealth planning, and professional advice, can help counteract the effect of cognitive biases.

• Be aware of biases driven by your emotions and personal experience. While everyone deals with their own biases, better decisions are made with a greater understanding of historical trends and facts.
• Create structure through comprehensive wealth planning can clarify your financial goals and the best path to achieve them.
• Engage with a reliable financial professional to create a wealth plan tailored to your goals can help you stay on track. A trusted advisor acts as a sounding board and provides guidance that helps you navigate your behavioral biases.

Understanding how cognitive biases influence financial decisions is crucial for improving outcomes. The mental shortcuts caused by biases such as anchoring, mental accounting, recency bias, and loss aversion can lead to decisions that are not always in our best interest, affecting everything from how we buy a home to how we plan for retirement. Increased awareness of our own biases and their potential impact, comprehensive wealth planning, and professional advice can help counteract the effect of cognitive biases. Ultimately, understanding and managing these factors will help us make more informed, rational financial decisions and increase the likelihood that we will achieve financial stability and success.

¹ Jorie Goins & Tribune Content Agency, “The most-searched financial planning questions of 2020,” Chicago Tribune, May 14, 2021, www.chicagotribune.com/2021/05/14/the-most-searched-financial-planning-questions-of-2020.

² Returns Filed, Taxes Collected & Refunds Issued, IRS, April 18, 2024, www.irs.gov/statistics/returns-filed-taxes-collected-and-refunds-issued#:~:text=The%20IRS%20issued%20120.9%20million,7%20XLSX%20and%208%20XLSX).

³ For more on this specific topic, please read our March 2024 Insights piece on Concentrated Stock Positions: Considering Your Next Steps, www.goelzerinc.com/insights_post/concentrated-stock-positions.

DISCLAIMER: The information provided in this piece should not be considered as a recommendation to buy, sell or hold any particular security. This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct. Actual results may differ materially from those we anticipate. The views and strategies described in the piece may not be suitable to all readers and are subject to change without notice. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. The information is not intended to provide and should not be relied on for accounting, legal, and tax advice or investment recommendations. Investing in stocks involves risk, including loss of principal. Past performance is not a guarantee of future results.

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