Getting to grips with your money is partly (only partly) an exercise in cutting out some of your bad, ingrained habits and putting in place good, empowering ones. The same with investing. Sounds simple, doesn’t it…?
Sometimes it feels like more of an art form, as you try out a variety of skills and strategies to improve how you spend, save, invest and basically live your life. There’s no real one-size-fits-all so it can be a game of simple trial and error. Some approaches will work better than others for you personally.
At the same time, there’s also a decent body of scientific work that shouldn’t be ignored that helps to explain why we do what we do.
In the many years spent within the world of wealth management, I saw all too often individuals consistently making the same investing mistakes.
It wasn’t so much about what strategies they applied, it was more down to what I would call a lack of “right thinking”. This is an inability to think in a rational and unemotional manner.
I include myself within that group, as we are all guilty of biases that we don’t notice or appreciate. In more specific terms we are victims of our cognitive biases.
The thing is, we like to see ourselves as rational beings, aware and in control of what we’re doing in our environment.
Unfortunately, we most definitely are not the rational beings we like to assume. We undertake risks that we shouldn’t, chasing rewards that we shouldn’t, making decisions that we shouldn’t.
But this trait is natural (human nature, if you will) and it’s something we have to accept as a part of being human. An important skill required to manage ourselves in this context is simply increased awareness. Once you are fully aware of what you are doing and why, you have the power of choice to help you master the situation.
So let’s dig a little deeper.
Of the many cognitive biases out there, here are two that a lot of investors a guilty of. These also manifest themselves in other areas of life:
We all appreciate the concept of ‘jumping on the bandwagon’. After all, that’s what fuels a lot of popular culture and the fashion industry. But going along with the crowd isn’t always the best thing for investors.
Those that can think back to the heady days of the turn of the millennium and were investing in technology stocks at the peak of the dotcom boom may appreciate the principle. And anyone that timed it wrong during the most recent property bubble may also vouch for the principle.
It didn’t mean that you couldn’t make money in the boom. It’s just that the risks of it not working out increased dramatically with time. And it most certainly did not work out well for everyone.
World-renowned investor Warren Buffett once gave the famous advice to be greedy when others are fearful and fearful when others are greedy. He essentially suggested we should not get sucked in by the bandwagon. Great advice as it is, most people don’t have the skills or mastery to separate an emotional response from a rational approach.
Investors may well feel more comfortable acting along with the crowd. It’s as if they can’t all be wrong whether the market is on the way up or on the way down. And ‘momentum investing’, where you hang onto the positive upward momentum in the stock market, can pay off for a little while.
But research has shown that over the longer term going with the herd doesn’t always end up being as profitable, particularly if you get caught with an investment bubble bursting.
One of the strongest biases that we have is that of loss aversion. Daniel Kahneman’s Thinking, Fast and Slow is a worthwhile read to understand the science behind the principle.
Essentially, we as humans dislike the idea of losing more than we like the idea of winning. It applies to so many areas in life but it’s certainly very apt when you are talking about your personal finances.
Research from the likes of Kahneman has shown that people tend to get disproportionately more upset at the idea of losing $100 than they do at finding $100. Or framed another way, the data has shown that people need to be rewarded twice as much (i.e. they find $200 in the above example) to get the same level of psychological redress as the amount lost (i.e. $100).
How does that relate to me, you may ask?
Basically, we care more about losses than gains. There will be times when you’re holding a stock in your portfolio that has fallen so much that you can’t stomach the idea of selling it. It was the hottest tip ever and yet it’s now the worst of fallen angels. In that situation, the right decision is very often to sell the stock and reinvest the proceeds into something with a better outlook.
After all, that stock may never recover and you could find yourself sitting on dead money. But that would be an admission of failure and we’re not keen on that. It would also be rational and we don’t always act rationally.
What It All Means
Well, it starts with awareness. By becoming aware of how we behave we can at least start to learn how to manage the way we think towards our many choices, allowing us to make healthier personal finance and investing decisions.
But being aware of these biases and acting in a way that doesn’t allow them to rule our lives are two entirely different things. Mastering our emotions and being able to take a step back are both parts of the battle.
It’s not something you can master overnight but if you want to get ahead financially, it’s worth starting with awareness before making conscious choices. We really have to get over the habit of sleepwalking through our financial lives.
I’ll share information on a few more of these biases in future posts.