Making financial decisions about investing or your financial future is not all about the numbers, it is also about psychology. As we have seen quite clearly in the last couple of weeks, markets tend to be erratic and often irrational, but being aware of your behavioural biases can help us cope when the market turns against us.
The study of the mind and behaviour as it relates to how we make sound financial decisions is a subject that is not only interesting but useful. Here are some cognitive and emotional biases that seem to have the greatest impact on investment performance:
This bias refers to the human tendency to dislike losses more than we like to experience a gain. In simple terms, people would rather not lose $100 than to gain $100. When investing during a down market, the sting of a loss could prevent an investor from taking on the level of volatility required to ensure portfolio growth over the long term. For those willing to put aside their emotions and invest while prices are low could reap the long-term benefits when markets recover.
This bias speaks for itself, as it represents the tendency for people to believe that they are better or more educated on a topic than they really are. When it comes to investing, we all know there isn’t a crystal ball, and it is hard to know with certainty which way the stock market will go. Overconfidence impacts our ability to make sound investment decisions based on the facts at hand.
This refers to the phenomenon to seek or interpret information in a manner that supports an already established view on a decision or topic. If someone believes that a specific company is a great investment, they have the tendency to only seek out information that supports this belief and discredit information that offers a conflicting view.
This bias refers to separating money into various subjective criteria. Think of a work bonus earned in addition to a regular salary. If someone earns $5,000 per month, they are more likely to use that money in a disciplined manner to pay down debt, save, invest etc. However, if that same person were to receive a $5,000 bonus, they are more likely to spend it with less thoughtful intention. The $5,000 is regarded differently in these two instances when in reality it’s still money that should be used in line with their financial goals. This is why it’s important to consider the entire financial situation as a whole and assess the impact each financial decision has on a long-term plan.
This speaks to the tendency people have in using their personal experiences to shape future judgement and decisions. When it comes to investing, people become anchored on a recent piece of news that they’ve heard, or a story told to them rather than relying on fundamental factors.
As we become aware of common biases, we can implement strategies to help guide us back to rational thinking and improve the decision-making process. One critical way to try and make rational investment decisions is by using a Strategic Asset Allocation (SAA).
An SAA is a portfolio strategy made up of a variety of assets such as cash, fixed interest, shares and property. It is designed to meet an individual’s long-term objectives in mind. The most important feature is that it does not change unless the individual’s circumstances change such as purchasing a property or impending retirement.
Instead of letting our biases take over, it becomes a case of rebalancing the investments back to the set allocation when certain asset classes perform either positively or negatively. The result is that investments are sold at the top and purchased when they are ‘cheap’ – the gamble is removed. The asset allocation is in place to protect us from ourselves and our biases.
While this is not as exciting as picking the ‘next big thing’, it takes out the unknown and drives more thoughtful and strategic decision making.
Hewison Private Wealth is a Melbourne based independent financial planning firm. Our financial advisers are highly qualified wealth managers and specialise in self managed super funds (SMSF), financial planning, retirement planning advice and investment portfolio management. If you would like to speak to a financial adviser on how you can secure your financial future please contact us 03 8548 4800, email firstname.lastname@example.org or visit www.hewison.com.au
Please note: The advice provided above is general information only and individuals should seek specialised advice from a qualified financial advisor. The views in this blog are those of the individual and may not represent the general opinion of the firm. Please contact Hewison Private Wealth for more information.