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Understanding Our Behaviour… Why We Make Terrible Investors!!

Much of the economic, investment and financial theory is based on the underpinning that people act rationally. 

However, a growing area of research has emerged in behavioural finance that shows rational behaviour doesn’t rule and unfortunately, is an impediment to us enjoying financial success.

The following are 6 of the key insights into our behaviour that if moderated, will greatly increase our chances of achieving our financial goals.

HERD BEHAVIOUR
Where there are investment bubbles, there is evidence of herd behaviour. We like see a track record of an investment having performed well and then get on board, quite often due to a fear of missing out. Or, to put another way, we get a bit greedy. Conversely, we are reluctant to invest in those sectors that haven’t performed well, or sell out of them.

However, the economy works in cycles and we go through ups and downs regularly. Fear and greed are 2 emotions that take over and invariably result in us buying high and selling low, the complete reverse of what we should be doing.

LOSS AVERSION
Nobel prize winner Daniel Kahnemann in his research found that a loss hurts 2.25 times more than an equivalent gain. This can result in us being irrationally risk averse and we miss out on some of the longer term benefits of growth assets. It also means when investing, we need to take time to understand the cyclical nature of returns and be mentally prepared for an inevitable downturn, but be confident there will also be an inevitable upturn!

ANCHORING
Anchoring refers to our tendency to focus on one piece of information, usually the first piece offered, when making a decision. For example, someone gives you a hot stock tip and tells you it is a $20 stock. If we buy, we have this as our benchmark and may hold until our dying day until it reaches it, or goes broke.

Similarly with property. We fixate on a price we think our property is worth and tend not to accept what the market is telling us. So we hold until eventually get the price we have in our mind and not factor in the opportunity cost of doing so.

FAMILIARITY BIAS
No we are not referring to our life partner but rather our tendency to use rule-of-thumb based on experience to make judgements. A useful trait in daily living, but not great when investing.

Commonly property investment is an example of this. We are comfortable with property, we understand the basics of how property works (rent and capital growth over time) and perception is low risk. However, having all your assets in one asset is in fact quite risky. And there are other characteristics of this type of investment that may not suit all situations or life stages.

MENTAL ACCOUNTING
We tend to think of money in a compartmentalised way, which affects how we behave. For example, salary is for living costs and bonus is for holidays.

This can work to your advantage if you have a financial plan, identified goals and have a disciplined approach. For example, deciding your Credit Card is only for “non-discretionary” expenses and to be paid off each month. Have a separate “holiday” bank account. Pay off your Credit Card and the 18% interest you save think in terms of 18% return on investment. However, if you don’t have a plan and be goal focussed, you can continue doing the same thing you have done previously and your goals will move further from reach.

GAMBLERS FALLACY
We can’t help but let past patterns influence out thoughts about future odds. If we toss a coin 3 times and get 3 heads, we assume the chances of then tossing a tail have increased. But the probability is exactly the same as the first toss.

Equally with investment markets the past is no predictor of future events. The pricing direction of markets in the short term is largely random and we should do our best to not act on short term movements as this will often derail our longer term investment plan.

In many respects we are wired for failure when it comes to investing. Investment market and economic theory doesn’t recognise we are “emotional” beings not rational.

This is why employing a trusted financial adviser to help guide and keep you accountable to your goals can be your best investment of all.

Aaron McCracken
Senior Financial Adviser

Contents from this article has been sourced from a White Paper developed and published by CadaretGrant and IN Research in May 2015.

written by:

Aaron McCracken

Aaron has over twenty years of experience in the financial services industry working with large companies and small businesses across all aspects of financial planning. He has broad experience across superannuation (including self-managed superannuation), investments, estate planning and personal insurance, retirement planning and business succession planning.
Aaron is passionate about the value of professional, client-focused advice and enjoys working closely with clients to help them make smart decisions with their money, as well as aiding them to clarify and achieve their financial aspirations.