How do we prepare ourselves for an uncertain financial future when so much is at stake?
Yesterday, a friend of mine asked me if I have ever recommended a client to go visit a psychologist because their money problems went beyond financial problems but rather were psychological problems. This got us talking. We are both in the field of finance and financial behavioral bias is something we are both too familiar with. I try to make aware of these biases to my clients, and instill some level of awareness of the dangers that can limit their financial success.
When it comes to managing money, one requires not only a sound understanding of the knowledge about financial products, investments, risk theory and also tax rules but also an understanding of the biases that we have as fallible humans that make mistakes.
I am normal, and not rational – we all are. I am just like you, but that has not prevented me from reaching my financial goals. I know how my brain can get in the way and drive me to me make financial mistakes. Managing money requires more than just being organized and knowing things about money.
The Brain
Our brain and the chemicals in the brain force us to make irrational decisions based on our emotional needs at any given time. Many investors have succeeded by acknowledging these behavioral biases and using them to their advantage. As such, I seek to highlight some insights of emerging science of personal financial decision making, so you will avoid following your emotions down the rabbit whole.
I will not get into the serious mambo jumbo science of how our brain makes decisions when it comes to financial matters. All you need to know is that our brain is in constant struggle to make financial decisions because we use two parts that are contradicting in nature i.e. the emotional part limits your ability to achieve your goals and the rational part keeps the emotional part in check and drives us to achieve our goals. Have you ever asked yourself why most people know they should save for the future, but they rarely do? They even justify why they shouldn’t.
The best plan is one that keeps our emotions in check, which means delegate your investment decisions by automatically saving into various investment schemes by setting up automated transfers into various investment funds – that is if you cannot avoid the emotional elephant when making decisions. That way the emotional elephant will never have chance to remind you of all the fun you could be having with all the extra cash.
However, If you want to manage your money yourself, here are some of the most common behavioral biases that drive people today and how to avoid them:
Overconfidence
Investors are said to overestimate their abilities to analyse investment information and identify the difference between market prices and intrinsic value of any given investment.
Overconfident investors have a tendency to put all their eggs in one basket because they are 100% sure that they will gain a lot.Assume, I have 1 million shilling to invest in a stock. I go out and do some equity shopping. I find a company I really like, conduct some due diligence and decide to buy as many lots that one million can buy.
At that time, the emotional part of the brain is excited and overconfident over the prospect. I mean the company has amazing growth prospects because the industry is growing and their plans sound legit to me. Moreover, everybody knows they are a good company. The emotional part of the brain is placing too much confidence in my abilities to predict the outcomes of my investment decision as I have managed to convince myself that I will make a lot of money because of the mere fact that I am excited about the prospect of that.
How to avoid this
(1) Diversify. Overconfident investors are mostly under-diversified and thus are more susceptible to market volatility. Hence, always diversify your investment as you may not be 100% sure that any given investment will perform as predicted even with all the due diligence done.
(2) Avoid Atypical Mistakes. Assuming that good companies are good stocks to have too.
(3). Face Your Loss. Avoid placing defense mechanisms by coming up with excuses as to why the investment did not work out. Defense mechanisms in themselves are related to overconfidence as they justify your initial reasons and blame bad events to sheer bad luck rather than your own poor investment choices.
Loss Aversion
Investors are said to be risk averse, meaning they dislike losing money more than they like gaining an equal amount of money.
For instance, take the 1 million I had invested. My stock increases in value for a sometime, and then it takes a hit and starts declining. During the time it was increasing in value I was very happy and comfortable with the risk I was taking. Yet, knowing the risk of a potential down turn as I was advised, I get uncomfortable and unhappy about my turn in luck because I dislike losing money (I mean who doesn’t).
The emotional part of the brain is controlled by fear and loss aversion then seems the natural step. So, I get jittery and sell the stock to avoid more loss. While in fact, as a rational investor I should I have invested more money into the stock because a common sense dictates that we ought to buy when everyone else is selling.
How to avoid this
(1) Minimize Regret. We all have regrets sometimes however; despite the fact that it is hard to forget bad memories, do not let them limit you. Replace those bad memories with good ones of wining times. So, do not avoid investing because you fingers have been burnt at stake or invest conservatively because you are afraid.
Herding
Investors have a tendency not to make their own guided independent decisions rather mimic investment action of others or move with the market.
Not uncommon, that is why pyramid schemes and other con gigs always seem to work. It is not foolish to question as we must always be very fearful when others a greedy. Imagine if I put all my money in a stock in which everyone is buying. By my own action, I too contributed to the rise of the price of the stock through my own buying action. The laws of the market dictate that prices will rise when there is a high demand for any good or service, even stocks. So when you jump into the band wagon, and participate in flocking the market to buy any given stock, the price is sure to rise. And guess what? There is some wise guy waiting. He will sell at the point he feels the market price for the stock is good for him and then subsequently triggers an action for selling. At this point, you will be left like, but I just bought the stock!! As the price moves back to its intrinsic value.
How to avoid this
(1) Think Independently. Do not follow the herd and be wary when people say “but everyone is buying it” as a means to justify their own participation.
(2) Avoid Framing Dependence. Do not buy high and sell low, instead use logic, not emotions and avoid the band wagon. Tolerate risk based on your own financial circumstances and not on the direction of others or the market.
Happy Investing!
Learn more about how to avoid being tricked out of your hard earned cash by following this link Red flags For Investment Fraud & Common Persuasion