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Our emotions often get the blame for bad judgement, but surely our financial decisions are in the sphere of clinical thinking and mathematical calculations! The answer is: No. Research has shown that our financial planning can be impaired quite drastically if we are not on our guard. These impetuses are referred to as behavioural biases and we are going to explore a number of these.
The most common seven biases are:
Loss aversion refers to the phenomenon that people are roughly twice as displeased with a loss as they are pleased with the same percentage of growth on an investment. This can have a paralysing effect on investors, causing them to be so fearful of a possible market correction that they never take the step to invest, thus potentially missing out on investment growth.
Confirmation bias may result in an unbalanced portfolio since this prompts an investor to be drawn to information sources that confirm his specific conviction even though it may not be accurate in his specific circumstances. An example would be where an investor focuses on the returns generated by a specific (preferred) asset class over a limited period and ignoring other principles of portfolio construction.
Mental accounting occurs when investors view funds from different sources as dissimilar. In Afrikaans we have a proverb: “Erfgeld is swerfgeld” meaning heirs tend to spend an inheritance much quicker than they do money earned. This is a perfect example of mental accounting as all funds should be treated according to the same investment principles to ensure a healthy portfolio.
Illusion of control bias can usually be spotted by use of the words “I should be able to . . . “. An investor is convinced that he should be able to pick the best shares, time the market perfectly or recognise the best investment property. This bias often result in trouble with managing expectations.
Recency bias is something we are all prone to from time to time. A good example is the invariable increase in sales figures for bigger cars after a decrease in the petrol price. This also holds true for investments where an influx of funds into a well performing fund can usually be seen, showing an expectation of good future performance based on the past success.
Hindsight bias can be summed up by the well-known phrase: “I knew that would happen!” This mental state can cause an over reliance on predictions, resulting in a portfolio with too much risk.
Herd mentality is used very successfully in the advertising world, but is just as applicable to investments and can lead to the inclusion of shares or instruments in a portfolio that is not aligned with the investor’s own goals and objectives.
We trust that this will result in a case of forewarned being forearmed and help you all to sidestep the possible pitfalls created by emotional decision making.
Source: http://tedxtaipei.com/articles/rethinking-thinking
Sources (all accessed on 17/8/2016):
http://money.usnews.com/money/personal-finance/mutual-funds/articles/2015/05/26/7-behavioral-biases-that-may-hurt-your-investments
http://www.investopedia.com/university/behavioral_finance/behavioral6.asp
http://blog.fundexpert.in/emotional-bias/
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