How human behaviour impacts our financial decisionsHow human behaviour impacts our financial decisions

The irrational behaviour you know

There are a lot of theories out there about how investing should work, but people don’t always act rationally.

We’re human after all. With a whole bunch of wonderful quirks and shortcomings that come along with being us.

But when it comes to investment decisions, this can turn us into our own worst enemies. Don’t panic though—being aware of these quirks can also help you overcome them.

Riddle me this

Let’s start with an example:

If a cricket bat and ball cost $1.10 together, and the bat costs $1.00 more than the ball, how much does the ball cost? …

Did you say $0.10?

If so, you’re not alone. Over half of students surveyed at Harvard and MIT gave this answer.

However… the ball actually costs $0.05 and the bat will cost $1.05.

This is an example of falling into a cognitive trap. And we don’t just have those, we have emotional biases too. Here are a few of the key ones to keep an eye out for …

Confirmation bias

This is when you only seek out views that you agree with, without seriously looking at any opposing information.

For example, if I think Apple is the best company out there then I’m more likely to read articles talking about what an amazing CEO Tim Cook is, and how the latest iPhone release is going to be phenomenal.

I’m less likely to look at negative reviews about battery life. And the latest operating system update… or look seriously at their major competitors who have made huge gains in the smartphone space.

Best defence

Actively seek out information from all points of view (as opposed to only things that support your thinking). Or get a friend to play devil’s advocate.

Anchoring bias

This is similar to confirmation bias, but it’s when you become fixated (or anchored) on a certain price for an asset—often the price you invested at, and refuse to accept that the underlying value of that asset has changed.

For example, if you bought shares in a company at $10 and the share price drops to $5, then people tend to hang on to it and refuse to sell until the price comes back up to $10, even if the worth of the company has changed and might never get back to $10 again.

Best defence

Always look at an investment with a fresh pair of eyes. Asking yourself if you would invest at the current price is a good way to see if you should hold onto something. If you wouldn’t buy an asset at the current price, then you probably shouldn’t.

Bandwagon effect (aka herding)

Humans tend to be pack animals. We feel more comfortable when we’re part of the crowd—this includes investing in the same assets.

But following the crowd when it comes to investing, can mean we end up investing when prices are high and selling when they are low—chasing the market in either direction. There are sometimes advantages in taking the contrarian view, and going against the pack!

Best defence

Before you join the crowd and jump into the latest ‘new shiny thing’, take a step back and ask yourself what the fundamental drivers of the investment are? Is the hype (or fear) warranted? Or is it already over (under) priced?

Loss aversion

Research shows that we feel much greater pain from a loss of money, than we get from an investment gain. And that loss is more than twice as painful as the positive feeling we get from a gain.

This loss aversion impacts us in a couple of ways:

• We’re more likely to spend now rather than save for the future. We feel the loss of not spending now, even though we stand to gain more in the future.

• If the value of our investments declines, we’re likely to wait until it goes up to sell it… On the upside, we’re more likely to cut our gains and sell once we’ve made a small profit rather than hold onto an investment.

Best defence

Be clear about the time frame of your investments. If you’re investing in high growth stocks, your minimum timeframe should be at least 5 years. And if you’re wanting to check the value every day keep in mind there will be plenty of ups and downs over that time! To help keep your saving habits on track, pay yourself first; set up an automatic payment to send a certain amount straight to your savings — this way you avoid seeing the money and being tempted to spend.

Familiarity bias

This happens when we have a preference for investing in something that we know — for most New Zealanders this is often the housing market. This can become a problem when you put all your eggs in the same basket, because you miss out on the benefits of diversification.

For example, if you own a house and an investment property, it might not be a good idea to also buy into a real estate investment fund. This would mean all our your wealth is tied to the real estate market leaving you very exposed to the ups and downs.

Best defence

Don’t put all your eggs in one basket. If you already own a house, it might be better to look at non-housing (and non-construction) related assets to diversify your risk of a housing market crash.

Overconfidence

We humans are optimistic by nature, which can be really great — who doesn’t love someone with a sunny disposition!

But when it comes to the world of investing this can be quite a dangerous one. We tend to overestimate the probability of good things happening to us (and, by extension, our investments). This can often increase trading volumes (and associated costs) as people feel they can beat the average market investor.

Best defence

Think about the downside risks first before thinking about potential upside and examine all possible outcomes of your investment.

Keep your eyes peeled

The first step to overcoming some of these biases is recognising when you are falling into their traps. Remember to keep your eyes peeled for these as you start or continue on your investment journey and good luck!