Understanding Financial Heuristics
Heuristics are the processes humans use to make decisions quickly using their past experiences and problem-solving skills; you might call them "rules of thumb" or "mental shortcuts." For example, when I make pancakes from the box, I use the powder mix and about 3 Mississippis of water; that is based on my experience making those pancakes and my judgment that day. That is what heuristics are, "rules of thumb" used by humans to save time rather than doing time-consuming analysis.
Heuristics have been with man since the rules of thumb were as simple as see tiger, run from tiger. But today, heuristics are applied to many aspects of our complex modern society, especially how we handle our finances.
These mental shortcuts can be very advantageous; they allow us to move throughout our day with relative ease because we can make "good enough" decisions. Let's take my pancake analogy: what happens if I am a little too generous with the water today? My pancake batter will be thinner than usual, and the pancakes that my children devour without a second thought will be a little less fluffy than they were on Thursday. In this case, the mistake from my mental shortcut was not a big deal.
Now, let's imagine a scenario where using a mental shortcut could hurt you. Imagine you are used to driving the same route from your house to downtown that takes 20 minutes; you have made the drive thousands of times and take the habit for granted. Today, you had an important interview downtown but encountered a traffic jam that held you up for at least 30 extra minutes. Had you broken your mental shortcut and taken the time to check the route during your regular morning routine you would have known to leave early. With this in mind, let's quickly review the “pros and cons” of heuristics.
Written By
Kristen Ahlenius
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We have discussed the general topic of time versus accuracy. Now, let's discuss the specific examples of bias that can create problems for our mental shortcuts and how they impact our financial lives.
Hindsight Bias
You are probably familiar with this bias, "hindsight is 20/20". We all think we had the correct answer after the fact, but our bias doesn't allow us to look back at our previous predictions. Hindsight bias can make us believe we “knew it all along,” especially when it comes to financial decisions. For example, after your car breaks down, you might think, “I should have saved for repairs—how could I not see that coming?” Similarly, when retirement approaches, you may think, “I should have started saving much earlier; it’s so obvious now.” However, predicting unexpected car repairs or imagining future retirement needs decades in advance is much harder than it seems after the fact. To avoid this bias, create proactive financial plans like an emergency fund or a realistic savings plan for retirement.
Recency Bias
Recency bias causes us to give too much weight to recent events and overlook long-term trends. For example, if you’ve recently had lower-than-usual utility bills during a mild season, you might underestimate your budget for heating costs in the winter. In terms of retirement, someone who recently received a significant raise might believe they’ll always earn at this level and delay increasing their savings, forgetting that income levels can change. People rely too heavily on what they have seen most recently for this bias. We will make decisions based on the newest information, which tells a story we like better than when it is included with past details. To avoid this bias, rely on long-term averages and projections rather than overreacting to recent financial patterns.
Confirmation Bias
This bias stems from placing too much weight on the information we choose to engage with. It can lead to poor retirement planning when someone focuses solely on information that aligns with their existing beliefs. For example, if a person is convinced Social Security will fully cover their retirement expenses, they might only read articles or listen to opinions that reinforce this idea, ignoring warnings that Social Security may not provide sufficient income in retirement. To avoid confirmation bias, actively seek out diverse perspectives on retirement saving and evaluate a variety of strategies, like employer-sponsored plans, personal savings, and potential side incomes.
Anchoring Bias
This bias occurs when we use a piece of information, like a number, to set our expectations for the future. The problem with this bias is that we focus too heavily on the anchor number and fail to use all the information we need to make a fully informed decision. There are many great examples of this bias impacting our finances, like when retailers increase the prices of goods only to turn around and put them "on sale" for all those savvy shoppers. The numbers you should anchor yourself to are the ones in your budget. An example in retirement might be when anchoring bias causes someone to fixate on a specific retirement savings number without considering whether it’s truly sufficient. For instance, they might decide $500,000 is enough because they heard a friend or financial advisor mention it as a goal. However, this “anchor” may not reflect that person’s specific retirement needs. To avoid anchoring bias, calculate retirement goals based on comprehensive, personalized financial planning.
Are heuristics bad? Not at all. But like anything, we must be mindful of how they impact our lives. Whether you are stirring up some pancake mix or making a big financial decision for you and your family, take a second to ensure you aren’t falling into a heuristics bias trap. You have the ability to make fully informed decisions and take control of your financial goals.
If you need guidance on your financial choices, connect with a Your Money Line Financial Guide for free financial coaching—a financial wellness benefit available to all Pension Fund members. Additionally, if you are ready to open a new retirement account and take the next step toward securing your future, contact a Pension Fund Client Relations team member today for personalized assistance.