Financial Decision Making: What is Behavioural Bias?

Humans are fallible. We are prone to act in ways which are intuitive, impulsive, and irrational. The same is true about our thought processes when making financial decisions. Making mistakes when choosing or utilising a financial product can be costly and is a clear risk factor when considering the potential for consumer harm.

Behavioural economics takes a psychological approach to understand people’s financial decision-making behaviour. Behavioural economics has long been of interest to the FCA, and the influence of this field of study is evident throughout the new Consumer Duty.

Within the Consumer Duty guidance, you will see frequent reference to ‘behavioural biases’. Biases affect people’s thought processes and can lead them into actions which are not entirely rational. We are all biased in some way – these biases can cloud our judgement, leading us to act inconsistently or to misjudge or misinterpret facts. Behavioural economics suggests that there are common biases that humans share and therefore common mistakes and pitfalls that can be predicted.

Traditionally, some firms have been aware of these behavioural biases and have exploited them in pursuit of sales, but in doing so, have encouraged customers into action that is not in their interest, thereby resulting in consumer detriment.

We must always bear in mind that the financial services industry is complex for the layperson. Most customers will not be experts and are therefore inherently disadvantaged and susceptible to making mistakes.

For instance, financial products are not tangible items that people can pick up, look at and examine. If you go to a greengrocer, for example, you can select your fruit and vegetables having made a judgement on the look, feel, size, and smell of the produce in front of you. The price of your intended purchase will be clear, with no risk of hidden costs.

When buying a financial services product, it is not as easy. These products are abstract, with various features and pricing structures. The complexity involved sometimes means that customers will only look at the headline information when selecting a product, thereby oversimplifying their decision-making.

As humans, we tend to focus on our current happiness and situation, without true regard for our future selves. This is known as ‘present-bias’, which is a tendency for individuals to prioritise their current pleasures and gratification over their long-term interests. A payday loan, for example, may appear attractive because it provides money quickly at a time of need, but as the months pass and repayments and interest payments must be made, the decision to enter the arrangement may be bitterly regretted.

Conversely, a person may choose not to take out an important insurance policy in the hope of saving some money in the short-term but if the risk then materialises, their future self will likely suffer loss for not taking out the policy at the time. Not everyone has the self-control and the discipline to look after their long-term interests at the expense of their short-term happiness.

Financial products, such as insurance, often require us to make decisions that involve uncertainty. This means people must make judgements involving probability and risk. Most people struggle to do this intuitively but may overestimate their ability to do so. This is a belief-based bias, in that people may be overconfident in their decision-making or financial projections, perhaps based on previous isolated successes.

Status-quo bias, for instance, means that people often feel more secure doing things the way they have always done them, even if better options are available. This is a cause of inertia and may result in harm if a product or service no longer offers the value that it once did, or if the customer is missing out on a better deal.

Our emotions also affect our decision-making abilities. Decisions are not always taken rationally based on a cost-benefit analysis but may reflect our anxieties, particularly our fear of loss or regret. Stressful situations can also lead to rash decisions being made without sufficient and proportionate consideration of the costs, risks, and benefits involved. As such, we may be biased towards decisions that seemingly address an emotional need, such as wanting to achieve ‘peace of mind’ when taking out an insurance product.

In addition to these preferential and belief-led biases, there are also biases which people tend to use to simplify decision-making when faced with complex information. Often people have limited attention spans and may be swayed by information that is framed or presented in an appealing or simplified way. Our biases towards our fellow human beings are also a factor in this. For instance, if you receive advice from someone who you consider likeable or charismatic, you may be more inclined to follow that advice than if it were given by someone who does not possess those desirable qualities.

In next week’s article, we will look at how behavioural biases should be considered by firms as they work to ensure compliance with the new Consumer Duty.

RWA has launched a Consumer Duty gap analysis to help firms implement the new rules and guidance. If you would like more information about this or require any assistance in relation to the new Consumer Duty, please contact your RWA Business Manager. Alternatively, get in touch via email at helpdesk@rwagroup.co.uk or call 01604 709509.