When it comes to financial decision making, it’s fair to say that humans are rarely rational in the choices we make. Our behaviours and emotions are capable of leading us astray and quite often they do! Sometimes these decisions can have an outcome that negatively impacts our financial future.
Behavioural economics is a rapidly growing academic field. It studies the effects of psychological, cognitive, emotional, cultural and social factors on our economic decisions. Behavioural economics can help us understand why we make the financial decisions we do, particularly when under stress.
We’ve all heard of the ‘fight or flight’ instinct. Through times of market volatility, decisions are made from this innate fight or flight response rather than reasoning and logic. At times of perceived ‘crisis’ for example falling markets, all our instincts are telling us to take action. The action taken is often to sell to remove ourselves from high stress situations, but that is often the worst thing to do. Selling when the market is low leads to consolidated loss, whereas patience can be rewarded.
Over the long term you are rewarded for keeping your investments, or even increasing your exposure to different markets, take advantage of the eventual market rebound.
There are several common biases or pitfalls to be wary of when making financial decisions.
Recency Bias is the tendency to focus on recent events and put more emphasis on new information than older data. For example, investors often think the share market will remain consistent and make decisions based on that. When the market is going up they buy and when it goes down they sell.
Confirmation Bias is where you have an existing idea or belief and seek confirmation by listening only to information that confirms those pre-conceptions. We tend to interpret and recall information in a way that confirms our beliefs, while ignoring information that disproves our theory. In the contemporary world we live in, we have access to infinite amounts of information that can support nearly any hypothesis we put forward in our minds. On the same day one news outlet might be predicting markets will fall, while another is stating that markets are on the rise. We filter only the information that supports our thinking and act accordingly. Confirmation bias interacts with recency bias.
Humans generally don’t like change and this is referred to as the Status Quo Bias. It is the preference for things to remain the same and a tendency to not change behaviour unless the incentive to do so is compelling. This minimises the risk associated with change but also means forgoing any potential benefits that may outweigh the risk. This often plays out with decisions around changing a provider such as health insurance or even an electricity company. Being familiar with the current provider, the costs and the benefits may lead you to stay as is rather than take a risk on an unfamiliar but potentially better option.
Studies show that we feel a loss twice as intensely as a gain. Loss Aversion is a preference to avoid a loss almost at any cost. Investors will often hold onto a stock that has dropped significantly in value with the hope it will eventually come good. In the natural cycle of market movements, this can be a good thing as often the stock will recover. However, where there is no hope for recovery we need to know when to admit defeat, sell to minimise the loss and invest elsewhere. Loss aversion could also be called FOMO (fear of missing out) and is at play when there is a perception of scarcity. This is why when something is advertised as only having two left, you feel compelled to purchase.
You may have picked up that some of these biases support one another while others contradict. A financial adviser can help you navigate these bias’, determine your short and long-term goals and, importantly, help you make smart and rational decisions to achieve these goals over time.
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