17 Nov Does mental bias mess with your investment decisions?
From time to time, financial planning can be a frustrating job. With investment decisions, a solid, long-term financial plan can be prepared and discussed with a potential new investor. The financial benefits of the plan may be fairly obvious, and the potential investor may even appear to be excited about the plan.
When it comes to implementing the plan, however, hesitation may take over and nothing gets done. It’s at times like these that a good, experienced financial planner needs a good understanding of human psychology. The potential investor’s mental biases or emotional make-up may be preventing the implementation of the plan. A skilled planner will be able to identify and address these issues in a subtle manner. In fact, it has even been suggested within the industry that financial planners consider working jointly with professional psychologists in certain investor situations.
What mental biases prevent you from making rational long-term investment decisions?
Perhaps the most common bias that I come across is ‘herding‘. An investor may want to imitate the behaviour of other friends and family, especially when they have heard the same story around the braai a number of times, and it involves everyone making great returns. A rational analysis of the available information may well suggest that another course of action may be more appropriate.
Another very common bias is ‘anchoring‘. This is the tendency to focus on a single value, usually a past value, to the detriment of making an objective analysis. Very few investors can ignore or forget the cost of a previous investment and this number is often imprinted on their brain. The past cost, when compared to the present value, will strongly influence their investment decision, even if there has been a fundamental change in their personal circumstances or the financial market environment.
‘Mental accounting‘ is also quite easy to identify. This involves an investor compartmentalising their various investments, instead of considering the part that they need to play in the overall portfolio. It is inevitable that different asset classes will perform quite differently over periods of time. This is quite normal, and shouldn’t result in an investor moving from one type of investment to another. It’s important to try and identify ones overall exposure to the various asset classes, as well as local and offshore, and determine whether it is appropriate for ones unique circumstances.
Other psychological factors may prevent an investor from making any investment decisions at all. ‘Choice overload‘ has been well documented, and can also be referred to as ‘paralysis by analysis’. Too much choice can in fact be a bad thing. The fear of making a bad choice may result in no choice at all. Perhaps it was easier to make decisions in the past when there were fewer financial products.
‘Loss aversion’ can also prevent investment decisions being made. Investors tend to feel a loss far more strongly than a gain of the same magnitude. This mental bias can easily result in a person being more conservatively invested than they really can afford to be in the long term.
Another common human mental bias, obviously not restricted to financial planning, is called ‘saliency’. This involves the tendency to overestimate the likelihood of a very unlikely event. Again, this mental bias may lead to an illogical financial planning decision. A child may have grown up with stories from their parents about a disastrous family investment and may have an built-in aversion to all investments of this nature, even thought the likelihood of a repeat experience may be very low.
‘Time discounting‘ is the tendency to regard current welfare as more important than future welfare. This is especially prevalent with young investors, who struggle to visualise an intangible retirement many years in the future. It’s far easier to visualise how the latest flat-screen TV will enhance your immediate welfare.
An experienced and ethical financial planner can use their understanding of mental biases to help a investor make beneficial investment decisions. Framing relates to the way that a problem or issue is presented. This can influence the response. For example, an investment with a 90% probability of achieving target over a certain time period may be considered acceptable to most people, but an investment with a 10% probability of failure may be perceived as being less acceptable, even though there are clearly identical probability outcomes.
If you think that your built-in mental biases may hinder your financial decision-making, my advice is to engage an independent, fee-based certified financial planner who is focused on your best interests and can provide impartial advice. If you do not know a certified financial planner, visit the website of the Financial Planning Institute on www.fpi.co.za to select one.
Debbie Netto-Jonker CFP® is the founder of Netto Financial Services and was Financial Planner of the Year in 2001. Her business partner, Ian Beere CFP®, was the Financial Planner of the Year in 2007.