It’s a difficult question to answer yourself without considerable bias. And 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, psychology professor Daniel Kahneman, brought to the forefront the study of Behavioural Finance, which explores the emotional biases that govern our financial decision making. Research conducted shows human beings are repeat offenders in the way they arrive at decisions; patterns of irrationality, inconsistency and incompetence when faced with uncertainty.
Some of the areas of observation about how investors respond when faced with financial decisions:
Loss Aversion
Loss aversion refers to our tendency to feel the losses more than the gains when it comes to investing. For example, if we had a 20% gain in an investment but also experiences a 10% loss in another investment, we’re more prone to feeling the loss than the pleasure feelings of the gain. Another example would be the focus on the risks associated before making an investment decision, rather than the potential gains.
Overconfidence
Confidence can be helpful but overconfidence, not so much. Being overconfident can result in greater risk because we either hold on too long to a badly performing investment or have a habit of conducting more trades which harms our 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).
Herd Mentality
Behavioural finance experts found 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.
Mental Accounting
A concept first named by American economist Richard Thaler in 1980, it states that people tend to segment their money into separate accounts for different goals, when in fact the funds derive from the same source. The best way to avoid the impact of mental accounting 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.
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Disclaimer: This post has been prepared for general information purposes only. It is not specific advice to any particular person. You should consult an authorised Align Financial adviser before making financial decisions. Align Financial | Financial Planner Northern Beaches | Servicing North Narrabeen, Narrabeen, Mona Vale, Elanora Heights, Newport, Avalon, Palm Beach | Enquire with us online.