How our behaviour influences our financial decisions
When talking about financial planning and investments, one needs to identify your future needs, life goals and objectives. However, even though this may seem like an analytical process, by simply taking into account risk profiles and applicable investment horizons, it is clear that the investor should be at the centre of the process and their motivations and expectations must also be taken into account.
One comes to the conclusion that there is also an emotional side to financial planning, the study of which is called Behavioural Finance. Behavioural Finance studies the way investors think and make decisions regarding their investments and the risks associated with it. A number of consistent biases have been identified in the way investors think, feel and act. Therefore financial markets are not always as rational as one would think.
Some observations can be made regarding the behaviour of investors:
- Investors are not as objective as they believe they are and thus are subject to systematic risk
- Investors are selective to pieces of information in order to suit their personal opinions
- All decisions contain emotional elements, specifically hope and fear
- Economists may sometimes be too confident in their predictions
- One becomes greedy when growth is peaking and sells out when prices have fallen.
Anyone or a combination of these traits can put one’s financial performance and objectives at risk. Human tendencies can lead one to be ignorant to information and to follow your own predetermined beliefs and notions. These are referred to as biases.
There are quite a number of biases that have been identified. Here we take a look at two of the main biases that affect your decision making process:
- Cognition: How you perceive and organize certain information that can also result in errors.
- Emotion: How you feel when evaluating the information
Cognitive Bias Examples
Investors tend to pay more attention to information that seem familiar and support their own perceptions and opinions, thus they would not seek information that contradicts their view. They often jump on the bandwagon with other investors that agree with them. This is very dangerous as it can result in missing some investment opportunities and making erroneous moves.
With this bias, investors often fail to adjust their investment portfolio to relate to their life-cycle. Unfortunately humans are creatures of habit and generally dislike change. This bias can be very risky as your investment profile can either be too high risk depending on your life-cycle or too conservative, e.g. a retired investor should tend to have an cash preservation approach with very little risk whereas a young investor should want high risk in order to generate capital growth.
These investors prefer to stay out of the markets; they miss out on the rallies and inevitably miss out on the returns. The risk is that you end up with less growth since most of these investors only invest in money market funds and cash, although you have constant growth, the return received over the long run may be much less than staying put in the bull and bear markets over a prolonged period.
Emotional Bias Examples
Loss Aversion Bias
This is an intense fear of investors that they may lose money. The risk is that they end up holding the investment for too long when they should be selling, and selling too early those that they should keep. Thus they end up increasing their risk and lowering their potential future returns. The human tendency of believing what goes down must go up creates a risk for your investment portfolio.
This investor believes he is more up to date with the markets than anyone else and has much more skill and experience when it comes to investment decisions. There’s a true saying that becomes relevant here, it’s not about how much you know, but rather how much you know you don’t know. Thus be humble and do your research.
Regret Aversion Bias
When one compares “what if” with “what might have been” you create indecisiveness for yourself. You regret making decisions and start to question your investment decisions. You regret that you did not buy into the market, or chose the wrong investment option. This bias is triggered when your actual returns and expectations don’t match up.
So how does one deal with these biases? The simplest solution is to rationalize your decision-making process by following these simple steps:
- Problem Identification: Clearly define your investment goals and needs.
- Generate Alternatives: Identify possible solutions to your goals & needs, such as sensible investment opportunities.
- Evaluation: Evaluate the investment opportunities and choose the most sensible one.
- Implementation: Implement the selected investment opportunity and review it against your goals/needs and investment horizon
In conclusion, when it comes to adjusting your investment portfolio, make your decisions based on your goals and needs, rationalise your biases and don’t let it guide your investment decisions.
- Written by Tarina Biewenga Mostert CFP®, Marketing and Communication Officer at Capricorn Asset Management part of the Capricorn Group.