Behavioural finance looks at the reasons we make the decisions we do around money, and the implications of those decisions. There is no question that our responses to external events as we build wealth over time, has a massive effect on the eventual outcome.
Our very humanity is, at some deep level, incompatible with the cold reason which is an essential component of building wealth. We know what we should do, but our emotions so often get the better of us.
Everything You Need to KNOW
1. Your Approach to Your Finances is far More Nuanced Than You Think
Whenever I meet a new investor, I always assess their risk tolerance. I take the outcome of the questionnaire with a massive pinch of salt, because they don't know what they're doing. They answer the questions as they think I might want them to answer.
More experienced investors tend to bring their real-life experiences to the questionnaires and hence the output from these is usually more reliable. But even so, these make far too many assumptions about our own self-awareness in the way the questions are posed.
You’d expect that we know ourselves more intimately than anyone else possibly can, but the experiences which make us who we are are far too numerous to count, and the interplay between these experiences means that our personality, character and outlook on life is uniquely complex. So complex in fact, that in truth we barely know ourselves at all.
When you bring that complexity to bear on an abstract concept such as building wealth, things get really challenging. How can we possibly know how we will cope with events which are not in our control, yet have a direct bearing on our financial security and sense of well-being?
The answer is that we don't know, and so we try to apply some of our past experiences, often in entirely different spheres of life, to our financial planning. More often than not, we do this unconsciously in the form of biases.
2. We Have Many Unconscious Biases
Part of truly knowing ourselves is becoming aware of these biases, and seeking to override them with common sense.
Confirmation Bias – we often resort to preconceived ideas when encountering something new. An investor suffering from confirmation bias will look for information that confirms his or her position. We tend to pay more attention to information that supports our opinions, sidelining information that challenges them.
Anchoring – here, we use spurious information as a reference for decision-making, rather than what’s actually going on, such as valuing a stock based on what we paid for it, rather than what the fundamentals show it is actually worth.
Another example might be where, as part of the financial planning process, a required growth rate is identified, and investments chosen in a bid to meet that required growth rate, even if those investments are unsuitable for other reasons.
Loss and Regret Aversion – this is self-explanatory. We all try to avoid pain and loss wherever possible, but sometimes we take this step further and hope to avoid the regret which comes from loss. It’s the feeling of regret rather than the loss that we seek to avoid.
Hindsight Bias – here we convince ourselves believe that a past event was in fact both predictable and avoidable, when in truth it was nothing of the sort. We can then try to apply that perceived predictability to future events, especially where circumstances appear to be similar than the previous event.
Familiarity Bias – This often happens when someone holds shares in the company they work for. Because they it and the management team, they buy more shares based on a confidence in the future which may be misplaced. This bias can also manifest itself in our asset allocation, when we stick to just to our home market.
Self-Attribution Bias – put simply, this is where we take credit for events going in our favour when in fact we had nothing to do with it. The fact that we chose to buy and hold a share which tripled in value was nothing more than good luck, no matter what we think.
Worry – we all worry to some degree. When we worry, our brains project forward possible future scenarios, almost always negative ones. We then apply the emotions is linked to these scenarios to our present-day decisions, which rarely makes for a good outcome.
3. Overcoming These Biases is a Lifetime’s Work
We will never overcome them completely, as they are as much a part of our human condition, as our ability to love, hate and hope. But this shouldn't lead to a fatalistic outlook. We need not be slaves to these biases. Instead, over time, we can learn to be aware of them in the moment of our financial decision-making, and to compensate accordingly.
In fact, if for a second we think we have fully overcome these negative biases, we have fallen prey to another human emotion, hubris. Of all of the human traits, hubris and arrogance are arguably the most dangerous.
The fact is, most of us have no idea what we're doing when it comes to investing, or more bluntly, you have no idea how to invest. If you've dabbled so far and had good experiences, that is largely down to luck and 10 years of rising markets. Markets will not continue to rise inexorably; there will be corrections both large and small and there's not a damn thing you can do about it.
You can learn how to invest according to years of Nobel prize-winning research, but can you stick to it over the kind of timescales required to build significant wealth? Can you commit to getting to know yourself better, even when that process is pretty uncomfortable at times? If so, then you have a fighting chance of succeeding with investing.