Feature Article

This example provides a great introduction to the topic of cognitive bias and, in the broader sense, behavioural finance. What exactly are cognitive biases? They are systematic thinking errors that influence our decisions and our judgment.

Cognitive biases are often the result of mental shortcuts we call heuristics, or “nudges.”¹ They are rules of thumb designed to facilitate decision-making. Our brain uses them mainly to simplify complex cognitive tasks. One of the main figures in the study of heuristics is Daniel Kahneman, an economics and psychology researcher who received the Nobel prize in economics in 2002. He wrote a book called Thinking, Fast and Slow² that proposes a theory of two separate thought processes, System 1 and System 2:

In the example of the ball, the first time I read the question, I gave the wrong answer. My brain used System 1. It assessed the situation too quickly and gave the intuitive and automatic response, which is that the ball costs 10¢. Then the slower, more analytical System 2 kicked in and provided the correct answer.

To find the price of both objects, the brain has to solve a mathematical equation that could be written like this:

• If the ball costs x, then the bat costs x + $1.
• Together, they cost x + (x + $1) = $1.10.

The answer to this equation is that the ball costs 5¢ and the bat costs $1.05. This is a deceptively simple demonstration, but it triggers the kind of shortcut we are inclined to use to zip past the analysis step.

¹ https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/nudge/

² https://en.wikipedia.org/wiki/Thinking,_Fast_and_Slow

Research on cognitive biases

Cognitive biases can be grouped into four broad categories, each responding to a specific challenge faced by our brains:

1. Too much information: Faced with the massive amount of information available, our brain filters out much of it, selecting what it deems to be the most relevant and concentrating on what seems most useful.
2. Not enough meaning: As the world is complex and information often incomplete, we fill in the gaps with our pre-existing knowledge and update our mental models to create a coherent perception of our environment.
3. Need to act quickly: In an uncertain environment, we need to make quick decisions by evaluating situations and simulating possible consequences, even with incomplete information, to avoid paralysis.
4. Limited memory: Our memory can't retain everything, so it favors generalizations and highlights. This process influences our future perception and reinforces our existing biases, helping us to filter and interpret new information.

These categories illustrate how our brain manages information, creates meaning, makes decisions and memorizes experiences to adapt effectively to our environment, while influencing the way we process, understand and react to information.

Cognitive biases deeply influence the behaviour of clients. Understanding these biases allows financial planners to guide their clients toward more balanced and rational decisions. Many studies have explored cognitive biases and their impact on financial decision-making, offering valuable insight for professionals in this field. Here are some examples.

Shefrin and Statman’s Behavioural Portfolio Theory (BPT)³, developed in 2000, offers an alternative to traditional investment theories by explaining how investors build their portfolios based on behavioural factors. Unlike classic financial theories, such as the capital asset pricing model (CAPM) or modern portfolio theory (MPT), which assume that investors are only seeking to maximize the value of their portfolio, BPT suggests that they have varied goals and create “behavioural” portfolios to meet a wide range of objectives.

According to this theory, a behavioural portfolio is like a pyramid, with separate layers, each with its own defined goals. The bottom layer is to prevent major financial problems, while the upper layers try to maximize returns and provide the possibility of growing richer. This approach causes investors to divide their money into various strata that have different objectives.

Another important study in the field of behavioural finance is based on recent research on the theory of planned behaviour. This study led to the development of a new theory to explain financial planning behaviour⁴. The exercise is based on an in-depth analysis of 30 relevant articles. The researchers identified three main factors that affect clients’ receptiveness to financial planning advice:

1. Financial satisfaction (attitude)
2. Financial socialization (subjective norms)
3. Financial literacy, mental accounting and financial cognition (perceived behavioural controls)

These factors directly influence the intention to adopt a behaviour related to financial planning advice and indirectly influence the actual adoption of such a behaviour. This new theory brings together different behavioural finance concepts to concisely explain clients’ behaviour in various areas of financial planning. The framework offers valuable food for thought for financial planners.

Another study⁵ examines the impact of age on financial decision-making. It says that the ages of 53 and 54 are optimal for making judicious financial decisions. At this stage of life, people have solid experience and intact analytical skills, which reduces financial errors. Financial decisions rely on the experience and intuitive knowledge acquired with age, reaching their zenith around 54 before starting to decline. This study also points out, however, that people in this age bracket may underestimate their life expectancy, leading to retirement planning mistakes, which is why it is important to help clients plan for the long term, taking increasing life expectancy into account.

Consequences for clients

These phenomena are more related to psychology than to pure finance or taxation, but it is important to understand them, because many human behaviours are influenced by cognitive biases and can interfere with the recommendations you make to your clients.

For example, in financial planning, some studies have examined “hedonic adaptation” or the cycle called the “hedonic treadmill”⁶. This refers to people’s tendency to quickly adjust to their new living conditions, whether they are positive or negative. This concept is important for understanding why increases in income rarely lead to a sustainable increase in happiness or satisfaction. For example, after getting a raise, a person might initially feel happier and more satisfied, spending their extra income on purchases or travel. Over time, however, they get used to this new level of income and start considering it to be normal, which can lead them to embrace higher aspirations. Often, the initial happiness related to some new benefit fades away, making way for a constant quest for new sources of satisfaction.

This phenomenon is related to the idea of “keeping up with the Joneses” and its Québec counterpart, the “voisin gonflable,” which both describe the social pressure to maintain a lifestyle at least equal to that of our neighbours or peers. This pressure can make people spend more than they can afford and undermine their short- and long-term financial planning. Many studies have examined the propensity toward overconsumption based on comparing ourselves with others. This kind of behaviour can lead to indebtedness and persistent financial problems, despite an appearance of prosperity.

And let’s not forget the “Diderot effect,” a social phenomenon named after 18th-century French philosopher and writer Denis Diderot. This occurs when a new acquisition leads to a series of other purchases to achieve esthetic and functional coherence. The purchase of a new chair may highlight the shabbiness of the other furniture in the room and lead to more spending to harmonize the look. This desire for coherence and harmony can provoke spiralling consumption where each new purchase demands yet more purchases. Many marketing strategies exploit this tendency, which encourages complementary spending. Psychologically, the Diderot effect heightens awareness of material goods and leads people to be more attentive to their possessions and their appearance. The constant quest for material improvements can create a permanent sense of dissatisfaction. Social comparison and the desire to be part of a group can push people to comply with that group’s consumption standards, augmenting social pressure and unnecessary spending.

As you know, financial planning involves far more than financial strategies related to the technical aspects of the practice, such as retirement and taxation optimization techniques. Nevertheless, our recommendations will not be implemented unless the clients sign on! This means we have to understand their thinking mechanisms in order to comprehend how they are reacting in certain situations and offer them advice that they will actually listen to and put into action. These examples echo some of the transversal competencies described in our recent financial planning competency guide. Luckily, you can expect to start hearing about these themes more often in Institute of Financial Planning courses and workshops!