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How Behavioral Biases Can Impede Financial Health

Behavioral Finance

While most Americans tend to show some form of behavioral bias, a new study finds that higher bias levels correlate directly with worse financial outcomes across a wide range of domains, from 401(k) balances to self-reported credit scores. 

In “The Financial Impact of Behavioral Biases: Understanding the extent and importance of behavioral biases,” researchers at Morningstar found that each of four specific biases they examined—present bias, loss aversion, overconfidence, and base rate neglect—were found to directly correlate with low financial health. They found that this holds true across all age, income and education groups. And higher bias levels were directly correlated with detrimental financial behavior, from failing to plan ahead to failing to save and invest.

As part of the study, the researchers analyzed a nationally representative sample of 1,200 Americans, connecting their demonstrated levels of bias with their assets and their overall financial health. Participants completed a “bias assessment” survey, which included questions for six biases and a measure of a person’s financial health. The biases included were: 

  • Present Bias: The tendency to overvalue smaller rewards in the present at the expense of long-term goals. 
  • Base Rate Neglect: The tendency to judge the likelihood of a situation by considering the new, readily available information about an event while ignoring the underlying probability of that event happening. 
  • Overconfidence: The tendency to overweigh one’s own abilities or information when making an investment decision. 
  • Loss Aversion: The tendency to be excessively fearful of experiencing losses relative to gains and relative to a reference point. 
  • Exponential Growth Bias: The tendency to underestimate the impact of compound interest. 
  • Gambler’s Fallacy: The tendency to believe that a random event is less (or more) likely to happen following a series of similar events—thus over (or under) predicting reversals in series like market trends.

The researchers found that the first four biases showed robust results, while the last two—exponential growth bias and gambler’s fallacy—did not and were of no statistical or practical significance. 

Like another nationally representative sample, they found that 98% exhibited at least one bias. Moreover, a majority of their sample reported significant (medium and high) levels on all four types of biases measured. 

About 82% of their population showed signs of having a base rate neglect bias to a point where it may impact them negatively, while nearly the whole sample—about 97%—showed signs of present bias.

In the case of present bias, higher bias scores increase the chances of having higher credit card debt, spending more than a person’s income, and procrastinating on enrolling in a tax-deferred savings plan, resulting in lower retirement savings. 

The researchers also found some significant differences between groups. For example, on average, younger people showed higher levels of overconfidence than older people. 

Similar results were seen for present bias, with significant differences existing between Millennials and Baby Boomers, with Millennials having the highest proportion of people with high present bias (13%) compared with Baby Boomers (4%). 

“Knowing about biases—especially your own—is a great step to learning how to avoid them in our daily life. However, that may not always be enough. Biases are a complex concept to wrap our heads around, and unless we know what they mean for our finances, we may underestimate their impact,” write Sarwari Das, Behavioral Researcher; Sagneet Kaur, Associate Director of Behavioral Research; and Steve Wendel, Head of Behavioral Science at Morningstar. 

How Advisors Can Help 

Since most people are not great at recognizing their own biases and it’s common to have a bias blind spot—which can result in detrimental financial decision-making—the researchers suggest that there might be a significant opportunity for financial services providers to address unmet needs in the market with high-quality bias assessment and mitigation services. 

“When it comes to their clients, advisors might have room for interventions that can help investors better understand their biases, while avoiding any behavioral pitfalls that might be caused as a result of these biases,” they emphasize. Furthermore, they suggest that advisors might consider reaching out to people who may be more vulnerable to biases and help them self-monitor their own decisions. 

As for techniques to mitigate biases, the Morningstar researchers suggest:  

  • slowing down the decision-making process by setting up decision-making “speed bumps;” 
  • setting objective trading rules that never change; and
  • trying to ignore the daily news and keeping an eye on the bigger picture by seeking out information that lends itself to making that bigger picture clearer.