Are These Two Biases Sabotaging Your Financial Decisions?

Decisions about what to do with our money can seem daunting, with challenges around every turn. Unfortunately, natural biases we have in evaluating information can sometimes hurt our ability to make better decisions. Just like everything else in life, our feelings and the mental shortcuts we use affect the way we make financial choices.

The good news is that there is an entire field of study called “behavioral finance” dedicated to uncovering the ways our decisions are influenced—and how those influences shape our actions in the world of finance and money.

For instance, we might avoid selling a stock because then we’d be forced to admit that we made a mistake, or we might open a credit card with a high interest rate because we like the idea of earning extra airline miles. What drives decisions like these are biases.

Below, we take a look at two of the more common biases that can creep up on us when we’re not looking: anchoring bias and recency bias. These are distinct concepts, but they’re so closely related that they often come along hand in hand when we’re trying to decide what to do with our investments. If we can recognize them in the moment, we’ll be able to make much better financial decisions, and our investment portfolios will likely benefit.

What is an anchoring bias?

Anchoring bias occurs when you depend too much on the first piece of information you come across (the anchor) on a given topic in your decision-making process. Basing your reasoning on that first nugget of information can significantly affect how you make judgments about everything else you learn during your research.

Say you’re negotiating a starting salary with a new employer—the first number your potential employer suggests might become the anchor. If you can negotiate higher pay from there, you might feel pretty good about the outcome, but perhaps your competitors might pay you even more. Conversely, if you cannot negotiate a higher salary—even if no other employer would match it—you might feel slighted about accepting that first offer even though it’s actually an above-market rate.

In the world of economics and investing, anchoring can significantly shape our decisions. If an investment analyst tells you that earnings for a particular company will increase and result in a 20 percent rise in the price of the stock, you might anchor to that number and disregard bad news in the future—bad news that might show that the initial return forecast was overly optimistic or is now unrealistic. In turn, the overly optimistic expectations you first heard may lead you to hold on to the stock even if it is unlikely to reach the target price you originally found attractive.

How an anchoring bias can affect perceptions

Anchoring biases can also affect our perceptions of current conditions. For example, inflation rates have been high in recent years, certainly well above the relatively comfortable levels we became used to prior to COVID. The rise in prices for everyday goods seems so severe in large part because we have anchored to old, outdated information. When we shop today for things like eggs, real estate or car insurance (or any number of other things), our perceptions of current prices are vastly distorted when we compare them to what we were used to paying just a few years back.

Why does the first piece of information affect each decision that happens afterward? Our brains are sometimes most comfortable operating from a set starting point. We want to plant our feet somewhere before we figure out where we should be going. It’s much easier for our minds to have a beginning reference—such as a 20 percent return expectation, a $2 carton of eggs or the initial starting salary—and make adjustments from there. But when we take shortcuts in our decision-making paths, we may not always get to the best destination. We might overpay for a stock, hold onto an investment too long, or miss other opportunities because our anchors have us tethered to outdated information.

Just being aware that we may have an anchor bias can help reduce its impact. We can make a conscious effort to critically analyze information for relevance, accuracy and current conditions, and then ask what other viewpoints could be relevant or look for more information. These steps can go a long way toward raising our anchors if “bad weather” is coming.

What is a recency bias?

Recency bias is also known as “availability bias” because the most readily available information that people can recall tends to influence the decisions they make.

One entirely relatable area that is often subject to recency bias is performance at work. While it can be challenging to recall the quality of work of an employee over 12 months, it’s much easier to remember how they have done more recently. Someone who was been inconsistent at their job earlier in the year but is currently completing high-visibility tasks might seem to be in better shape compared to a more consistent counterpart who hasn’t had any big wins in a while but has been reliable the entire year.

How a recency bias can impact investing

Having a recency bias may cause us to put too much focus on short-term market trends and assume that long-term fundamentals like valuations aren’t as relevant. Recent economic news can have an outsized impact on financial plans because, much as with anchoring, our brains want to evaluate things from a starting point. If we can remember something easily, we tend to focus our evaluation on that vivid memory. Since recent and widely available information is typically fresh in our minds, the recent past tends to work its way into our long-term decisions more than it otherwise should.

This may lead to overreacting to short-term market movements, making impulsive financial and investment choices on what happens to be on the news, or chasing hot stocks and investment strategies because they’ve been working so well lately.

What can we do about recency bias?

As with anchoring, just being aware that we might be using the recent past to predict how the future will look is often enough to keep us out of trouble. We should take a long-term approach to financial planning and investment decisions. Forcing ourselves to consider other alternatives and reviewing our decision-making processes can definitely help out as well. With a more comprehensive perspective, we can reduce the impact of any misjudgments that come from recency bias.

Of course, identifying our own personal biases can be more difficult than it sounds. That’s why working with a Northwestern Mutual financial advisor, who will take the time to get to know your personal situation while providing you with a broader perspective, can be a good solution. It’s a great way to design an investment plan specifically suited to helping you achieve your goals.

This article is for informational and educational purposes only and should not be interpreted as investment advice. All investments carry some level of risk including the potential loss of all money invested.