Do you ever wonder why you didn’t engage with your superannuation earlier in life or bought something on sale when you had no intention of spending any money? We all make decisions like this, and it’s because our minds are wired that way. It’s how we’ve evolved.
The study of behavioural economics looks at the intersection of money and psychology. When it comes to decisions about money and investing, sometimes we can be our own worst enemies (and we may not even realise it) because of what’s called ‘cognitive bias’. Here are three ways that our minds can affect our investing habits specifically. Recognising and understanding these biases can help us combat our autopilot responses.
We’re all attracted to new, impressive numbers when we come across them. Recency bias makes it easy for us to recall and prioritise something that’s happened recently over something that happened further back in the past.
It’s easy to get excited by a small-cap gold miner that your neighbour says returned 20 per cent last month, or an emerging lithium stock that is all over the news. Strong recent performance can be too alluring to ignore but we don’t easily recall all the small-cap stocks that have failed over the years (and there are a lot).
On the flip side, a recent correction in the market can loom large in your mind when you’re considering whether to make a new investment, and you might feel more cautious than usual because it’s easier to remember the sensational headlines than the good returns that preceded them.
After we identify an investment we like (whether it’s a share or a property) we look for information that supports our opinions and we discount anything that differs from that. Confirmation bias is very hard to side-step – it’s like a brick wall that won’t let certain information past unless we recognise the bias.
A good fund manager will actually seek out information that challenges their opinion to try to mitigate this bias, and a smart investor should do the same thing. To compound this, investors may project a very narrow set of likely future outcomes as a result of their overconfidence in the decision they have made.
When I was playing AFL, the feeling of losing a grand final had a much greater effect on me than the elation I experienced when I won an AFL grand final. This is because the fear of losing something is twice as powerful as the desire to gain something. We need to be aware of this, as our instincts may be to sell investments once we see a headline predicting a potential correction or crash in the market (and these headlines are always easy to find). The power of loss aversion may lead us to sell our investments at the worst possible time.
So what can we do about this?
You can start an investment diary, in which you write down the reasons for making your investment decision. This allows you to accurately monitor the effectiveness of your decision-making process. You can also conduct a ‘pre-mortem’ (as the name suggests, the opposite to a post-mortem) before making an investment decision. In a pre-mortem, you write down why the investment might fail in the future, which can mitigate confirmation bias.
Checklists can help protect investors from overlooking potential pitfalls, but are by no means the panacea. A checklist will be most powerful in gathering data beforehand, not just the mere fact of ticking boxes. Doctors and pilots use checklists, which significantly reduce the chance of human error in their professions.
An ASIC report released last week found that almost nine out of 10 investors had not sought financial advice in the past 12 months, even though a third had received some advice in the past. With all the reasons identified above we can see that we’re not always rational with our decisions so help with finances can be beneficial, but it’s often expensive.
There are now low-cost alternatives to face-to-face advice such as digital or ‘robo’ advice. The ASIC report found that more than a third who had thought about getting advice but had not gone ahead were open to using a digital advice product such as Six Park, where I’m the director of business development.
Important information: The information provided on this website is of a general nature and for information purposes only. It does not take into account your objectives, financial situation or needs. It is not financial product advice and must not be relied upon as such. Before making any financial decision you should determine whether the information is appropriate in terms of your particular circumstances and seek advice from an independent licensed financial services professional.