Admitting you’re an emotional investor is actually pretty hard, but acknowledging your emotional biases might be just what you need to make more rational decisions.
Are you an emotional investor? It’s a difficult question itself to answer without considerable bias. If you sat down and asked yourself about the types of decisions you make every day about your money, your answer might sound something like this:
“No I don’t make decisions based on my emotions. I am definitely objective about the financial decisions I make. Really, I am.”
We all like to think we’re making sound decisions based on logic and unaffected by emotions. But the reality is that our decisions may not be as unclouded as we think.
The 2002 Nobel Prize winner, cognitive psychology professor Daniel Kahneman and his colleague Amos Tversky, developed the study of behavioural finance. It explores the emotional biases that govern our financial decision making. Research conducted showed that human beings are repeat offenders in the way we arrive at decisions; patterns of irrationality, inconsistency and incompetence when faced with uncertainty.
Let’s take a look at some of the observations made about how investors respond when faced with financial decisions.
Loss aversion refers to our tendency to feel the losses more than the gains when it comes to investing. The result is that we prefer to avoid losses more than we want to obtain gains.
For example, if we had a 20 per cent gain in one investment, but also experienced a 10 per cent loss in another investment, we’re more prone to feeling the dissatisfaction of the loss than the pleasure of the gain.
Another example would be when people focus on the risks associated with an investment decision, rather than any potential gains.
The biggest trouble with loss aversion is that inhibits your ability to correctly measure opportunity cost. You will hang onto a loss-making investment in an effort to recoup your losses, rather than cut and run to a better opportunity.
Confidence can be helpful but overconfidence, not so much. It’s the egotistical belief that we’re better at something than we actually are (like making good investment calls).
Overconfidence is remarkably prevalent in the investing space. Analysis by Dresdner Kleinwort Wasserstein found that 74 per cent of fund managers rated their abilities as ‘above average’; the remaining 24 per cent thought they were ‘average’. Which aside from being statistically impossible, is also quite worrying when these are the guys looking after your investments.
You might be prone to overconfidence yourself. It can result in greater risk for a several reasons: inappropriate lack of caution; holding on too long to a badly performing investment because you don’t want to be ‘wrong’; and having an illusion of knowledge about or control of an investment that just isn’t there.
Or you can simply fall into habit of conducting more trades than you should, which harms your ability to make sound investments over the long term.
(As an aside, studies have shown that men are more prone to high risk-taking behaviour than women.)
With a herd mentality, investors tend to follow and copy what other investors are doing. Rather than relying on their own information to support their investment decisions.
Behavioural finance experts have shown that investors tend to place too much worth on other people’s judgements, especially when it’s from a small group or “expert” source. Wanting to do what others are doing for fear of missing out or that other people have more knowledge than we do, might make us feel like we need to follow the crowd.
Having a herd mentality bias can impact your investment decisions. It creates asset bubbles (where a false trend is started by the market itself) and market volatility. Passive investment can be one way to avoid herd mentality and become a less emotional investor.
Mental accounting is a concept first named by American economist Richard Thaler in 1999. It’s the set of cognitive operations people use to keep track of their financial activities. They mentally (and sometimes physically) segment their money into separate accounts for different goals, when in fact the funds derive from the same source. Having the separate accounts means you classify money based on subjective criteria, which can lead to irrational spending and investment decision making.
To counteract mental accounting, Thaler emphasised the concept of fungibility: that all money is mutually exchangeable and should be treated exactly the same. The best way to avoid the impact of mental accounting and become a less emotional investor is to focus on the total return of your portfolio and not fixate on a single investment.
It’s difficult to recognise the emotions behind our own behaviour in a non-biased way. Seeking objective help from a financial adviser can help implement a plan and stay on track to reaching your financial goals.
This is an edited version of an article that originally appeared on Align Financial and is republished here with permission. This article contains general information only. This should not be relied on as independent finance or tax advice. If you are after specific professional advice, speak to your registered tax agent/financial advisor or reach out to Darren at Align Financial.