We often blame our emotions when we exercise poor judgment, and, contrary to what we may believe, our financial decisions are not based purely on logical deductions.
Research has shown that our financial planning can be impaired by behavioural biases. The most common biases are:
• Loss aversion. Research has found that investors tend to be more displeased if their investment makes a loss than they are pleased if their investment grows by the same percentage. This phenomenon can have a paralysing effect on investors, because their fear of a possible market downturn results in their not investing at all, and so they lose out on potential to earn investment growth.
• Confirmation bias. This prompts investors to be drawn to information that confirms their already-held convictions, even though the information may not apply to their particular circumstances. An example is where an investor focuses on the returns generated by a specific asset class over a limited period and ignores the other principles of portfolio construction.
• Mental accounting. This is when investors view money coming from different sources as dissimilar. In Afrikaans we have a proverb “erfgeld is swerfgeld”, which means that heirs tend to spend the money they inherit faster than the money they earn. All money, however it is acquired, should be managed according to the same investment principles, to ensure a healthy portfolio.
• Illusion of control. This bias can usually be spotted when investors say “I should be able to”. Investors are convinced they can pick the best shares, time the market perfectly or recognise the best investment property.
• Recency bias. We are all prone to make decisions based on favourable events in the recent past. Investors often pour money into the latest top-performing fund, assuming that past performing is an indicator of good returns in future.
• Hindsight bias. This bias can be summed up by the well-known phrase “I knew that would happen”. It is the tendency for people to believe that a past event was predictable. This mental state can result in investors becoming too reliant on predictions and constructing portfolios with too much risk.
• Herd mentality. Going along what other people are doing without making your own assessment of the situation can result in your including investments in your portfolio that are not aligned with your goals and objectives.
How can we avoid these potential pitfalls? The first step is to acknowledge that we are prone to behavioural biases and to guard against them when making financial decisions. Second, having a financial planner with whom we can share our feelings can help us to avoid these biases.
Hester van der Merwe is a financial planner with Ultima Financial Planners in Johannesburg. She is an accredited Certified Financial Planner.