Your Money and Your Brain

Your Money and Your Brain

When students in the US were asked to assess the quality of their driving skills compared with other drivers in a survey, 93% of respondents rated themselves as above average. Statistically, that’s an impossibility and a prime example of the ‘overconfidence’ that so many people display in their own ability to complete various tasks. Have you ever tried tiling a bathroom? Made a Masterchef meal from scratch, or completed your own tax return? Can’t be that difficult right? Wrong. If you’re anything like me then disasters and bad results abound. Likewise, believing that you can make a ‘good go’ of handling your own finances could be based on a biased view of your own ability, which in a worst case scenario could end up costing you the whole of your financial future. Only this month, former multi-millionaire sportsman Boris Becker was declared bankrupt, primarily for being overconfident in his ability to make obscure Nigerian investments. Why oh why?

But overconfidence is just one of a multitude of human traits, emotions and heuristics (mental shortcuts/rules of thumb) that we’ve developed during thousands of years of evolution to help us progress, survive and make quick decisions. They’re hardwired into our brains, called upon instinctively, and generally serve us well, however, when accessed involuntarily during the course of money management, our natural responses can seriously trip us up. The study of these psychological impulses and their impact on our financial decision making is known as ‘Behavioural Economics’ and research shows us how, why and when our minds play tricks on us with the objective of helping us to make better and more rational financial decisions.

It’s a broad subject that I’m completely fascinated by, and having experienced first-hand what can only be described as smart, well-informed people making truly terrible financial decisions primarily down to their behavioural biases, it’s an area of finance that non-professionals know very little about and the one discipline that I believe has the greatest impact on end results over time. It’s a big subject but to get you started, here are three common behavioural biases that negatively impact your bottom line if you allow them to.

Overconfidence – We’ve touched on this earlier, but when it comes to managing money, you’re probably not as smart as you think you are. And sorry, a high I.Q. or expertise in one field does not translate into financial competence. If you’re an existing client of Bunker Riley then you probably already realise this otherwise you wouldn’t come to us for planning and advice but for other readers, it’s a cautionary tale. In addition to the high profile cases like Boris Becker, I’ve personally seen a number of investors lose money needlessly, or not reach the financial outcome they had in mind, having taken financial matters into their own hands. A skim of the Sunday papers and the reading of very possibly one book (if any at all) does not make you an expert whose financial decisions can be relied upon. They say it takes 10,000 hours of practice to become an expert at anything so unless you’ve been putting in 4 hours a day, 5 days a week for the last 10 years to improve your financial planning, investment knowledge and experience, you really should go and get a professional opinion. And as much as we as advisers are professionals in our field, we do acknowledge our own limitations. Instead of trying to be overly smart by forecasting investment returns or timing the market, we take the higher probability approach of diversifying, tax planning, keeping costs low, managing risk and holding for the long term, which over time is proven to work.

Loss Aversion – On the opposite side of the coin, many people irrationally fear losses much more than the benefit of a gain, so much so that they make sometimes wildly unsuitable financial decisions. They’d rather hoard cash to prevent the pain of a capital loss, even when they have long term goals such as financing retirement that require above inflation returns. A completely rational ‘Dr. Spock’ would accept the pain of a 5% loss with the equivalent restraint as the joy a 5% gain. But that’s just not how people work. Emotions and doubt come to the fore and on numerous occasions I’ve told a client that they made a 5% gain only to receive a ‘meh’ reaction, compared to the total panic of an equivalent 5% loss. That just isn’t a balanced response and as mentioned, the fear of a loss can become such a problem that people either choose not to invest in the first place or if they do they are unable to stay the duration, even though these choices compromise the long term goal. If there’s one thing that very successful investors do, it’s that they educate themselves to accept losses for what they are, a natural and normal part of the long term investment process and not something to be considered as unexpected. Ultimately you have two choices. Keep your money in the bank at a return significantly less than inflation and hope that you can save enough in your lifetime to support a 30-year retirement, or take some risk in assets that have a reasonable chance to increase their value over time. I know which one makes sense.

Recency Bias – We tend to be lazy, naïve or both and assume that what has happened recently will continue. A free range turkey getting fat on the farm thinks life is great until without warning CHOP! Christmas arrives. Likewise, investors often assume that rising assets will keep on rising and falling assets will never stop falling. It’s imperative that you take a broader perspective and put in place an acceptable financial plan to meet your circumstances and goals even when times are good because believe me, you won’t get a memo before things change. If you’re currently holding more higher risk assets than you would usually be comfortable with purely because recent returns have been good, this could come back to haunt you, just as fearful investors remaining in cash after the financial crisis missed out on the significant recovery beginning early 2009. You shouldn’t try to predict what will happen next, but investing purely on the basis of recent events is probably not a great idea.

These are just three of the many documented psychological biases that cause us to regularly make poor financial decisions. We’re all susceptible to them by smaller or greater degrees but what is in no doubt is that they do exist and you won’t realise that they are affecting your decisions. It takes an outside eye to see where you could be going wrong and in my experience resolving some of the more obvious problems leads to a healthier financial outcome. There is, of course, a veritable library on this subject and I’d suggest that some further targeted reading will assist. For that reason, I’d highly recommend ‘Why Smart People Make Big Money Mistakes and How to Correct Them’ as a light introductory field guide and ‘Thinking Fast and Slow’  if you want to read what is commonly agreed by professionals to be the authoritative (more detailed) chapter and verse.

Follow me on Twitter @alexandreriley

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