The secret to avoiding bad financial decisions

So let's (virtually) toss the coin… it flies in the air, you call tails, it lands, rolls a bit and there's the Queen's head glinting up at you. You've lost. Does that make it a bad bet?

The upside of winning was huge, the downside of losing tiny. Therefore betting was a good decision based on the information available – it was the outcome that was bad.

In the less binary, real world, people tend to beat themselves up wrongly believing they made a 'bad decision' even though they actually made the right call at the time.

This sort of smog-tinted hindsight can be dangerous as it conditions you to become unnecessarily risk averse, which skews future decision-making – it's called snake-bite bias.

A real-life example is those who fixed their mortgages in the months just before interest rates started their rapid plummet. If the reason for fixing was to lock in for the peace of mind of a set rate rather than risk market variance, it was a good decision, just a bad outcome.

Many will say "they should've seen it coming", but that's prescience after the fact. There was no, nor is there ever, way to truly know what would happen.

These crystal-ball-needed decisions are unavoidable throughout life – should I take a lump sum or extra income on my deferred pension? Is going to university worth it? Is that the right house to buy? Even, will I be happy if I marry him/her? 

The key to making good decisions is to understand the difference between a good outcome and a good decision.

How to avoid poor decisions

It's a better person than me who can hand on heart say they always cope with the uncertainty that life throws at them. We crave for certainty even where it can't exist.

This is just one of many emotional biases that can hit good decision-making. The growing field of behavioural finance is dedicated to assessing these, often at the rarefied levels of high-end city investment banks.

Firms like Essentia Analytics build software to identify inappropriate biases. These include…

• Projection bias – where we assume our future selves will be in a similar position to where we are now (one of the reasons many under-save in pensions) 

• Recency bias – where people give far more weight to recent events than older ones

• Regret aversion – where the fear of getting it wrong blinds us to taking even appropriate risks

Those of us without the protective mechanisms of industrial finance need to formulate our own methods and structures to ensure we at least do our best to make the right decisions. That's why it's crucial that financial education has finally started on the English National Curriculum, teachers at least touch upon this kind of soft skill decision-making – such as "when it's right or wrong to borrow".

A decision-making checklist.

Of course, the most important starting point is to ensure you understand the product, rules or subject you're dealing with, but even after that, these can help…

• Establish the product particulars. Find the current prices and always check whether you're locked into the decision once it's made.

• Explore best and worst case scenarios. Play these scenarios out against your own finances to personalise the outcome. Think carefully about your attitude to risk – what's more important? The opportunity to do well, or to avoid the risk of doing badly.

• Know yourself. If you need to be active to make a deal work, such as a short-term savings account with a bonus rate that you'll need to shift again in a year – question whether you'll actually do that. Not based on your financial fervour during the heat of sorting out your money, but looking back at your behaviour history – we tend to be creatures of habit.

• Are you being clinical? It's easy to lust for something better, eg, to ignore the fact the house is a little beyond your reach because you love it. This bias makes poor decisions (even though that can still occasionally lead to a good outcome).

How these 'should I's' work in practiceOf course, a theoretical list is fine, but it's important to put some practical steps into it.

• Should I… fix my energy tariff?

  A far easier decision than it used to be, as currently all the market's cheapest deals are fixed and many have no early exit lock-in penalties so you can cut costs, get a guarantee of no price hikes, and are still free to leave if others' prices drop. 

  Those on a big six standard tariff with typical usage can save about £240 a year by fixing. The www.CheapEnergyClub.com has a top pick fixes comparison which will find your cheapest and see if you can save, and then also monitor your tariff after that to tell you if you need to switch again.

• Should I…. keep my shares until they bounce back, they've dropped from £10,000 to £5,000? There's no financial law that says what goes down must go up. Your shares are now worth £5,000, what they were worth in the past is irrelevant to the decision – cut the emotion out. 

  Instead ask yourself, 'would I choose to invest £5,000 now in these shares?' If the answer is you'd never dream of putting new money in, and think there are far better uses of the cash elsewhere, take the loss and sell. The fact you've held the shares for a while doesn't change the risk. If you do think they're a good potential investment at this point, perhaps as you believe they're now undervalued, keep them.

• Should I ….switch my bank account, to escape the terrible service I get?First Direct has won every bank customer service poll I've ever run, with 92% of customers rating it as 'great'. I'm swamped with warm feedback and it currently pays you £100 to switch to it. Yet a woman stopped me in the street recently to say: "I followed your recommendation to switch to First Direct, the service is awful. What a bad decision!”  

  The logician in me wanted to reply that it was actually a good decision, most people get vastly improved service – just a bad outcome as she was in the 2% of people who rate it as poor. Of course what I actually did was listen, smile, nod and sympathise.

  This is a common issue with customer service. I've never yet mentioned a cheap broadband deal where someone hasn't emailed to say, "take those abominable bounders off your list, I couldn't get any connection", even if thousands of others love it.

  Individual cases make for bad rules. Though they can be indicative of an attitude to dealing with problems, agglomerated feedback, if available, is better. It doesn't mean things will be perfect, just that you've a better chance of it being so.

• Should I… fix my mortgage?

  It used to be you needed to pay substantially more for the security of a fix. Today comparing a 75% LTV mortgage with similar fees, on a two-year deal the cheapest variable is 1.34%, the cheapest fix 1.59%, on a five-year deal the fix wins at 2.49%, compared to 3.39%.

  The decision is far less about rates today and more about what will happen to variable rates over the next few years. As they're still at historically anomalous lows, there's little room for them to drop far – though the Bank of England Governor did recently moot he may cut rates if we get hard-core deflation.

  Yet it is of course more likely that they'll rise with economic recovery – economists currently predict this will happen early in 2015, though they are as likely to change their mind as a teenage girl discussing which member of One Direction she prefers. Some predict the 'new normal' will be 2% or 4%, but it could be higher – in the 1990s of course we saw double-digit rates.

  Even with all that though, far more important is to examine your own personal finances and attitude to risk. How comfortably could you cope with rates rising? If it'd be a struggle to keep afloat even with small rises, bias yourself towards the certainty of a fix.

• Should I…. quit my job, take a £10,000 loan and travel the world for the year?

  A 23-year-old woman asked me this via Twitter. She wanted to do it before she started her career properly, had commitments, a boyfriend or family. 

  This isn't a yes or no answer, my view was she should avoid the loan. Work for another six months to a year, saving every penny possible, then use that to fund a life-broadening year (she was planning to work as she travelled so some funds would've come from that). After all, saving and debt both involve paying for something each month from your income, but with saving, you do it in advance and they pay you.

  I put the answer out to Twitter, and responses were polarised between those in the 'sensible' camp like me and others who thought 'grabbing every opportunity' was more important than anything else.

I’d love to hear via the discussion link below, when in your life you’ve made a good decision with a bad outcome, or vice-versa.  Or how you try to get rid of personal bias in your decision-making process.