Why is it important to understand biases and brain science?
Conduct regulators and culture supervisors, such as the UK’s FCA, central banks and prudential supervisors from the US to the Netherlands and beyond, want to know what financial firms are doing to prevent biases from disrupting proper business decisions. Similarly, by actioning this, you may avoid an enforcement action against your firm for misconduct.
What are some more Groupthink-related biases?
- When we’re trying to guess the value of an asset whose value is unclear, we tend to fixate on the first bit of information we see. We used the first found information point as the basis or anchor for any later guesses. For example, often the first price quoted to you acts as a reference point that distorts your view.
- This is a form of social influence. For example, in many social situations, particularly where we are conscious of our status, we go with the flow and keep quiet, as opposed to disagreeing out loud.
- This is a problem you can all see in front of you, hoping that someone else will intervene rather than you yourself stepping up either to fix it or to challenge the source of the problem.
- Expert Bias
- Putting too much faith in one’s own talents, knowledge or skills, or putting blind faith in an expert who’s been drafted in to give topical advice. The conduct regulator is very keen that firms show a culture of “healthy challenge”, which welcomes reasonable questions.
- Risky Shift
- A group starts to make collective choices that are far stupider and more risky than the chives any one member of the group would make, if you asked them on their own. This bias is prominent among traders during bull-run markets and among board of directors in firms that are on an acquisition spree. This evidently leads to asset price values and plummets values.
Which biases are the world’s conduct regulators most concerned about?
- Also known as selective information. This bias can be explained by “it depends how you look at it”. Because our brain tends to select information, if the information is presented in a selective way, we are likely to look at a market opportunity in a way that doesn’t properly focus on the risks that come with it. For example, an unwary buyer might over-estimate the value of a packaged bank account as it's presented in a positive way without mentioning any drawbacks
- Rules of Thumb (Heuristics)
- When faced with buying something with a complicated set of specifications, for example a car, we may choose one based on some surface characteristic. So rather than choose a car for its specifications, we just buy a blue one.
- Generalising and Over-extrapolation
- In financial marketing, this can mean buying a product based just on looking at last year’s investment returns and wishfully thinking that these imply the same or even higher returns in the future.
- Mental Accounting
- People think of their own money as being divided between different ‘pots’: some is kept to pay bills, for holidays, mortgage and so on. Hence a customer who does not mentally picture their money as fungible. This can be a conduct problem of allowing customer detriment.
What are some everyday bias traps that we may fall into?
- Halo Effect
- This is if you’ve ever bought something mainly because you like the person selling it. For example, if you’ve ever seen a celebrity or influencer endorsing a product, then you’ve gone and bought a product, that purchase is the halo effect. In terms of financial markets, beware of a charming or over-friendly salesperson.
- Spotlight Bias
- We tend to assume that we’re noticed more by other people than we really are. The conduct problem here is that a long-term customer may assume that you are keeping them in mind, when in fact you’ve stopped thinking about their needs. You may be causing them detriment by ignoring their current situation.
- Action Bias
- The way we often assume it must be better to “do something, anything” than do nothing. However, have we actively considered leaving things as they are? Are we taking these steps because we can robustly predict a positive outcome, or are we just doing something because other people expect us to look busy?
- The gap between the reality of what’s happening and how you explain to yourself what's happening. It’s a discomforting clash that you might experience between your own thoughts, beliefs or attitudes and a contrasting reality.
- This is a cluster of biases that come from our animal brain’s primitive instinct to spot predators, by finding meaningful patterns in possibly hostile environments. Our brains use sense-making to intuitively make sense of incomplete information.
What is regret avoidance?
This is a positive form of risk-averse behaviour, which for example is what leads us to seek peace of mind by buying insurance. However, regret avoidance can also push us into harmful behaviours: a trader sentimentally holding onto a favourite position for far too long when the price is falling; or a salesperson hitting a hesitant buyer with ‘last chance’ offer to artificially crank up the customer’s speed of decision.
What are the two forms of sense-making?
- False hindsight
- For example, “surely they must have known that such and such was going to happen?”. Instinctively we like to believe that we’re much better at forecasting than we actually are - this can lead us to take on too much risk.
- Sharpshooter fallacy
- The label for our tendency to use hindsight, or find motives or justifications that weren’t actually there.