Traditional economics holds that people process information in an objective and unbiased manner. The reality, however, is that most people process information in a manner that is far from objective. People have a tendency to make decisions that are too heavily influenced by readily available information that can lead to suboptimal outcomes when an overly simplified, heuristic approach is substituted for more rigorous analysis.
Memories are Biased
Simple memories that can be easily recalled are typically relied upon more heavily than memories that are either more difficult to understand or harder to recall. As such, recent events are often over weighted in the decisions that we make. Biased memories, however, only cause suboptimal outcomes when they lead to overly simplified, heuristic decision making. “Common sense” rules of thumb and “educated guesses” are examples of heuristic decision making, which can be defined as an experience-based, problem solving technique.
According to research conducted by Amos Tversky and Daniel Kahneman, heuristic decision making can work well for certain types of decisions. Unfortunately, the more complex the decision, the more likely it is that a heuristic approach will result in what is referred to as attribute substitution, which involves substituting an easily understood attribute for a target attribute. This can lead to situations where easy answers are inappropriately grafted onto difficult questions in an overly simplistic way.
With interest rates near record lows, many Americans have benefited from refinancing their mortgage. Nevertheless, a recent survey that was conducted by Harris Interactive for Lending Tree indicates that many consumers do not shop around and compare different refinancing offers.
This survey of 1,380 homeowners found that although 9 out of 10 American adults compared prices when shopping for large purchases, fewer than half of homeowners compared different options for mortgage refinancing. Unfortunately the cost of not shopping for a competitive mortgage can be huge because the wide range of interest rates that are offered by different companies can result in thousands of dollars in extra mortgage payments each year.
So why is it that over half of homeowners don’t shop around when refinancing their mortgage? Many consumers perceive mortgages as complex financial products, so they use a simplified, heuristic approach instead of more rigorous analysis. Accordingly, a lot of homeowners will impulsively accept the first offer to refinance that is presented, while others will simply use the same loan officer that they have used in the past. Yet, current technology makes it relatively easy to compare rates from different lenders. It’s not hard to avoid an overly simplified approach. In addition to web-based tools, working with a mortgage broker who has access to multiple lenders is a good starting point. So, the next time you are looking to refinance your mortgage, remember that a little shopping around can go a long way.
Investment advice is another area where consumers are susceptible to availability bias. Too often investors base their opinions about investments on advertising that creates readily available memories. Analyzing thousands of mutual funds and adjusting their returns for risk is a complex task; and instead of taking a logical approach, many people will simply turn to the mutual fund companies with the most familiar names.
Availability bias can also cause investors to limit the pool of investments that they select from. For example, an investor may decide that no European stock is worth buying because of the ongoing sovereign debt crisis in Europe. And even professional investors can be affected by this bias. As an example, an international equity portfolio manager once told me that he would never buy stock in a Japanese company because Japanese corporate balance sheets are too hard to understand. The reality, however, is that these investors may be missing important opportunities by relying on the familiar at the expense of more thorough analysis.
If you have experienced this tendency to over simplify complex financial decisions, consider consulting a CERTIFIED FINANCIAL PLANNERTM professional from the Financial Planning Association that has the experience and expertise necessary to guide you.
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, CA. He serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.