“Man is his own worst enemy.” ? Marcus Tullius Cicero
We all know that we are inherently flawed. We are emotional creatures, easily socially influenced with limited self-control. Case in point: the irresistible lure of a packet of Tim Tam (we often behave irrationally, making decisions to our detriment. Just ‘one’ more Tim Tam wont hurt…).
And when it comes to managing our money, this irrational behaviour can result in “self-sabotaging” our financial goals.
But don’t despair! Fortunately our behavioural biases are predictable – a systematic error in our programming. This predictability means we can recognise our biases, understand where they come from, and hopefully overcome them (often by ‘re-biasing’ or using them to our advantage).
Where do biases come from?
Biases are personal.They areformed by our own experiences including what we’ve seen or heard, actions we’ve taken, how our family, community and others have behaved around us.
Biasesinfluence our behaviour in both conscious and unconscious ways, ensuring there is always a battle between intuition and logic.
We only began to understand how cognitive biases shape judgement around 50 years ago thanks to psychologists Daniel Kahneman and AmosTversky.
Kahneman went on to win the Nobel prize for his work on prospect theory.
What are some of the most relevant biases in finance?
Prospect theory starts with the concept of loss aversion; an observation that people react differently between potential losses and potential gains –“losses loom larger than gains” (Kahneman & Tversky, 1979).
Essentially, the pain of losing is psychologically more powerful than the pleasure of gaining.
For example, if somebody gave you a $100 bottle of wine, we may gain a small amount of happiness (utility). However, if we owned the $100 bottle and dropped it, we would be more unhappy (Isuspect we need to assume the dropped bottle was full).
In an investment context, an example of loss aversion is holding cash and choosing not to allocate it towardother(higher risk) investments. Some people feel safer with their money under the mattress (or in the bank), and this feeling outweighs any possible potential gain from investing their money in a logical fashion.
To combat loss aversion, try framing the situation as a potential gain. Another way to tackle loss aversion is to put things in perspective, possibly by asking yourself ‘what’s the worst that couldhappen?’.
Generally, not to getting too emotional about your investmentsand keeping a long-term view isuseful.
The Anchoring Effect
The anchoring effect is a “systematic influence of initially presented numerical values on subsequent judgments of uncertain quantities”. In other words, showing someone a number can influence their estimate of the value of an unrelated item.
Take the example of the jewellery industry’s famously contrived ‘diamond anchor’.It suggests‘two month’s salary’ should equate to the price paid for an engagement ring.
Logically, we know an engagement ring should be dictated by what an individual can afford, so the irrelevant anchor of the two-month salary only serves to maximise the profits of the jewellers
In an investment context, anchoring is prolific in the stock market with the ‘price’ of something not necessarily reflecting intrinsic worth.
An investor may be fixated on a company’s recent ‘high’ stock price and consequently believesthe drop in price provides an opportunity to buy the stock at a discount.
To avoid anchoring, try to engage in more critical thinking by using a variety of benchmarks or perspectives.
Another bias playing out inour currently volatile economy is recency
bias –it involves being “easily influenced by recent news or experiences”.
Recency bias is a cognitive bias where people tend to favour recent events over historic ones, even if they are not relevant or reliable.
I likenit to someone not wanting to go for an ocean swim after watching the movie Jaws, even though the risk of being attacked by a shark is nominal.
Recency bias may lead investors to think a stock market downturn or rally will extend into the future. In foreign exchange trading,traders have the tendency to look at only the most recent events, while disregarding older but equally important (or sometimes even more important) pieces of information.
A common culprit of inaccurate employee performance reviews, recency bias occurs when recent trends and patterns in behaviour and performance overshadow past actions.
This is a dangerous bias because milestones achieved at the beginning of the year should be factored into formal reviews as much as what happened last week.
The best way to combat recency bias is to try and take a step back and see the full picture.Again, reeling in your emotions to stay true to your long-term financial goals.
A close relative ofrecency bias is herd mentality our intrinsic tendency to follow and copy what others are doing, under the assumption that they know more than we do.
We are wired to have a preference for the busy restaurant over the quiet one. Surely the food is better at the busier restaurant, right?As social animals, it’s not hard to see why we behave like this.
In the financial sector, investors may follow what they perceive other investors are doing, rather than relying on their own analysis. The herd mentality is what drives market bubbles and bursts, like those seen in the early 2000s.
It’s similar to the way animals react in groups when they stampede in unison out of the way of danger—perceived or otherwise.
It’s actually psychologically painful to be contrarian.
Those not following the herd may be fearful,but having a disciplined valuation framework for your investments can help keep your emotions in check.
Biases in superannuation:default and framing
When it comes to our superannuation decisions, we are not immune from making poor decisions thanks to behavioural biases – despite our funds mostly being ‘locked away’ until we reach preservation age.
In fact, people tend to make poor financial decisions in situations where benefits will only be realised in the distant future.
Studies found pension investors are subject to framing and default effects in investment options.
Framing bias occurs when people make a decision based on the way the information is presented, rather than on the facts alone.
Default bias is where people prefer to carry on behaving as they always have,even when the circumstances that might influence their decisions have changed.This is because default choices don’t involve much mental (cognitive) effort.
When considering default and framing biases, it’s easy to see how the design of a retirement system or plan has a profound effect on participant investment and saving decisions.
Some argue policymakers can alter behaviour in fundamental ways by choosing different default structures.
We encourage all individuals to understand the ‘cost of doing nothing’, or staying with your default fund,when making a choice about superannuation.
It’s an all-too-common tragedy that people are often loyal to a brand or product that may no longer suits their needs or values.
Don’t be hesitant to change out of fear of the unknown.
Now you’re aware of some common biases, we trust this will help you to be more responsive, and less reactive to emotional factors.
Continue to reflect and educate yourself about your own particular biases, as this will ultimately help you to take back control of your relationship with moneyand help you to achieve the life you want.
For further reading, you can check outKahneman’s book Thinking Fast and Slow. For those with less time, watch the BBC horizon documentary or read this frighteningly long list of cognitive biases.
About Elevate Super
Elevate Super is a retail super fund, powered by successful fintech AtlasTrend. AtlasTrend was created in 2015 to build a new investment service to help our customers learn and invest with purpose in long term world trends. At Elevate Super, we believe you shouldn’t have to give up competitive financial returns to do good.
We assess and measure investments based on their long-term growth fundamentals plus positive contribution to the UN Sustainable Development Goals (SDGs) – a global blueprint for balancing our economic, social and environmental needs.
Elevate Super is a sub plan of the Aracon Superannuation Fund (ABN 40 586 548 205) (Fund) issued by Equity Trustees Superannuation Limited (ABN 50 055 641 757, AFS Licence No. 229757, RSE Licence No. L0001458) (Equity Trustees). AtlasTrend Pty Ltd (ABN 83 605 565 491) is the promoter of Elevate Super and an AFSL Corporate Authorised Representative (No. 001233660) of Fund host Limited (AFSL 233045) (Fund host) and Havana Financial Services Pty Ltd (AFSL 500435) (Havana). This communication contains general advice only and does not take into consideration your personal objectives, financial situation or needs. None of the information provided is, or should be considered to be, personal financial advice. The information provided in this communication is believed to be accurate at the time of writing. None of AtlasTrend, Equity Trustees, Havana, Fund host or their related entities nor their respective officers and agents accept responsibility for any inaccuracy in, or any actions taken in reliance upon the general advice provided. A copy of AtlasTrend’s financial services guide can be found at www.atlastrend.com/fsg.
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