Misbehavioural finance

Are investors their own worst enemy?

Working man

Behavioural finance is the study of why rational people make irrational financial and investment decisions. At The Wealth Corporation’s recent retirement seminar series, Director Peter Nieuwoudt referred to Father of Behavioural Finance, Daniel Kahnemann, and his celebrated book Thinking, Fast and Slow.

In the book, Kahnemann speaks of how a firefighter instinctively knows when to evacuate a burning building and a chess grandmaster instantly recognizes a lost position. This is because they have trained their brains to the point where slower, calculated analysis of the situation is no longer required.

Kahnemann describes the brain as having two separate operating systems. System 1 operates intuitively and quickly with little mental effort, whatKahnemann describes as “thinking fast”. System 2 requires reason, deliberation, concentration and problem solving, so-called “thinking slow”. The workings of the mind are an uneasy interaction between the two systems. While “thinking fast” can be of great advantage to the firefighter and grandmaster, System 1 can lead us to make false assumptions. 

The cost of delay

The biases of our intuition lead to errors of judgment. For example, when asked how much you would consider contributing to save an endangered species like the rhino, the real question you are likely answering is how sympathetic you feel towards the plight of the rhino at that point in time. These are two very different questions, the answers to which are based on different criteria.

This is a particular problem when it comes to saving for retirement. When you are asked how much you need to save for the future in order to realise your goals, the question you are likely answering is how much money you are willing to forgo now in order to save something towards your future.

Availability

A further two heuristics we tend to fall prey to are that of the so-called “halo effect” and availability (whereby we mistake the frequency of events for ease of recall). For example, according to one study cited in Kahnemann’s book, respondents believed that diabetes caused four times as many deaths as accidents. In fact, accidents cause 300 times the number of fatalities as diabetes. The vast discrepancy between popular perception and reality can be attributed to the high profile of diabetes in the media at present.

Turning back to behavioural finance, when it comes to investing, the heuristic of availability means people are more likely to choose to the “brand” of investment house or product they are more familiar with and incorrectly assume that its high profile must mean that it is the “best”. 

The halo effect

In the same way, the halo effect leads us to select the investment house or product that has received the most favourable results and exposure in the recent past under the false assumption that this trend will continue. What investors should be doing is choosing the investment product that best suits their time horizon and investment goals. As with the rhino question, the decision making process behind the question of which investment product to choose is not as simple and transparent as you would assume.

Hindsight is 20:20 vision

Hindsight can cause us to reconstruct our initial beliefs and falsely attribute motivation or cause and effect to something. With hindsight, many analysts were able to track the trends that led to 9/11 where none was able to predict it. In the same vein, we consider an investment manager’s good decisions a “no-brainer” and their bad decisions ones which could and should have been avoided.

Framing

You will be familiar with the phrase, “It’s not what you say but how you say it”. This is well-illustrated by the effect of framing on decision making. If you are told by a surgeon that your odds of survival post-surgery are 90% you are likely to feel far more confident than if you are told there is a 10% chance that you will die within a month. In investment terms, you will be far happier to hear that you will be able to spend 70% of your current income in retirement than if you are told you need to eliminate 30% of your current expenditure.

Conclusion

The only effective way to break the cycle of fear and greed that undermines investor returns and to avoid the errors of judgement referred to here is to follow a process. A competent financial advisor will be able to construct a financial plan around your current and future needs and goals, and act as a sounding board to help you to make well-considered financial decisions.

In essence, the study of behavioural finance teaches us that the main motivator in many financial decisions is not money, but self-regard, achievement, fear of failure and regret. We see this in how you feel greatly pained to sell your house for less than you paid for it, regardless of how great a steal you may be getting the new house you plan on buying.

Neil Viljoen, Regional Head at The Wealth Corporation

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