Personal finance behavioral bias
You would be naïve to think that the daily financial decisions that you make are made in isolation from your emotional ones. In our very first article, we asked you to consider what money meant to you; was it a source of security, or perhaps a form of social acceptance?
Personal finances go hand-in-hand with our upbringing and our personalities – which is why they’re personal. It’s better to be aware of how our thoughts affect the financial decisions we make, and how we might be sabotaging our best efforts despite trying to improve our knowledge, ala WellSpent.
People do not always act for the betterment of their long-term self-interest. While you may read that markets are largely efficient and that past returns cannot be an indication of future returns, it’s easy to assume that because a unit trust was the top performing fund for the last 5 years that it’ll somehow give you great returns going forward.
You are not in control of your own head
We’ve listed below a few common biases or human traits that can wreck a good financial plan. Your best bet is to at least be aware of them. We’ve linked them back to some of the fundamental principles we’ve been trying to drive home so you know where to apply steadfast caution.
The fear of loss
You don’t need to be an investing genius or be incredibly in touch with your inner-self to recognise your lack of willingness to accept any form of loss. Given two choices, most people would prefer to forego the chance of a gain, than expose themselves to the chance to experience a loss.
Like fear being the path to the dark side, so the fear of loss leads to risk aversion. Risk is required to generate any meaningful real return should you wish to accumulate a meaningful retirement balance.
You cannot let your fear of losing money prevent you from exposing your investments to risk. Risk can be managed through diversification, but cash under a mattress will only generate fishmoths.
This is one of our favourties.
People respond to financial news like a heard of wildebeest. New money follows recent performance.
You’ll read that “past performance is not indicative of future performance”, but that does not stop people from totally ignoring the basic principle of efficient markets.
Everyone loves a trend or pattern. Too easily though, people will concoct their own, which most likely includes backing winners and bailing out from a ‘losing’ Fund.
To accept the spurious relationship that somehow one Fund who randomly performed well last year, will again perform well this year (all else being equal), is to believe that because a coin landed on heads 10 times in a row, that the odds of it landing on heads again is anything but 50/50.
If you find yourself wanting to, or worse yet, actually picking individual shares to invest in, please read our article on how to retire like a tortoise.
The planning fallacy
Most of us love to feel in control of our destiny; our investment returns included. Feeling as if we are always in control can lead to us overrate our abilities, with a dash of optimism.
We underestimate the time it will take to do things, the cost to achieve them, and assume the results will surprise us on the upside.
This is why tasks generally take longer to complete, projects run over budget, and investing goals are not met. There are no shortcuts to long-term investing and no amount of researching or looking at charts will grow your money.
Long-term investing is boring and takes time. Accept that and save yourself countless hours of wasted effort.
Get rich slowly
By accepting and appreciating the basic personal finance principles that we’ve gone through with you over the last several months, you will automatically be protected from yourself. If you accept that a diversified portfolio of asset classes is your best bet at generating a meaningful real return in the long game, you’ll avoid being paralyzed by risk aversion.
Accepting that a passive investment portfolio will over time, generate superior returns to that of an actively managed Fund or your own best trading efforts, will save you from your folly for thinking that Fund X or Fund Y is the best one to be in, simply because their television ad struck an emotional chord, or because they’ve advertised a return that sounds as if it’s particularly good.
Stick to the plan
Everyone should have a sound investing plan in place that disregards emotional biases and that relies rather on steadfast, data-dependent, and rational decision making. A good financial advisor can guide you through this.
When you’re tempted to sell everything when markets appear to be crashing, they’ll ensure that your emotional actions are removed from your investment ones and that you stick to the plan.
You fail to plan, you plan to fail!
We will deal with the idea of ‘market timing’ in an upcoming article, but we understand that it’s tempting to jump into the market, or jump out, in response to visible winners and losers. You must understand that this is only with the benefit of hindsight.
Hindsight is free, seeing the future requires a miracle.
Simply backing winners and avoiding losers, implies that past performance is indicative of future returns, and no credible financial institution will ever admit that they honestly believe this.