Every day, we are faced with a huge number of big and small decisions. So, it’s perhaps no surprise that understanding how people arrive at their choices is an area of cognitive psychology that has received attention.
Research has found that several factors influence decision making, including:
- Past experience
- Cognitive biases
- Age and individual differences
- Belief in personal relevance.
When it comes to making financial decisions, the same factors come into play. While we know choices should be based on logic, it is inevitable that emotions, previous experiences and other factors influence the decisions we make. It’s natural that the cyclical investment process – research, information, choosing investments, holding, selling investments, and making new elections – are full of psychological pitfalls.
All this means that successful investing requires you to be aware of the psychological traps that you can fall into. Here are some of the ways that behavioural psychology can affect investment decisions.
Would you rather win £50 or not lose £50?
As financial planners, we don’t get many calls when we’ve reported a £25,000 gain in a client’s portfolio. However, you can be sure that the phone will ring if we report a £25,000 loss!
A loss always appears larger than a gain of equal size. For example, research has found that, when asked to choose between receiving $900 or taking a 90% chance of winning $1,000 (and a 10% chance of winning nothing), most people avoid the risk and take the $900.
This is even though the expected outcome is the same in both cases.
However, if choosing between losing $900 and take a 90% chance of losing $1,000, most people would prefer the second option (with the 90% chance of losing $1,000) and thus change to a riskier behaviour in the hope of avoiding the loss.
Loss aversion theory explains why investors hold onto losing shares: people often take more risks to avoid losses than to realise gains. This means that investors often willingly remain in a risky position, hoping a share price will recover. It’s much the same way that a roulette player will double up bets in a bid to recoup money they have already lost.
So, despite a rational desire to get a return for the risks we take, we tend to value something we own higher than the price we’d normally be prepared to pay for it.
Are you only looking for opinions that match your own?
Confirmation bias refers to our tendency to look for opinions that align with our own or put more faith in such viewpoints. If you’re on social media, then such an ‘echo chamber’ can be easy to find!
However, if you focus on the opinions that support a view you have already established it can result in imperfect decisions. For example, investors often base their decisions on the first source of information to which they are exposed, such as the initial purchase price of a share, and have difficulty adjusting their views to new information.
Are you as good at investing as you think you are?
Overconfident investors believe they have more control over their investments than they really do. And, as investing involves making complex forecasts of what may happen in the future, overconfident investors can overestimate their abilities to identify successful investments.
This is linked to ‘self-attribution bias’ which occurs when investors attribute successful outcomes to their own actions and negative outcomes to external factors.
Why buying local could be the wrong move
While it’s easy to understand the benefits of diversification, research has found that investors prefer investments that are ‘familiar; in terms of their own country, region or company.
For example, Columbia Business School research found that, in 49 out of 50 states, investors are more likely to hold shares of their local regional telephone companies than of any other telephone company. Additionally, it has been found that investors also prefer domestic investments over international investments.
Beyond a geographic familiarity bias, investors also tend to prefer investing in their own employer’s shares. As well as risking holding too much of their portfolio in one specific asset, this can also be dangerous for employees as they risk compounding losses if the company performs poorly: first, in loss of compensation and job security, and second, in loss of savings.
All this means that familiarity bias can lead to a lack of diversification, potentially increasing risk.
Avoiding a red face
Regret theory deals with the emotional reaction people have when they realise they have made an error in judgment.
In investment terms, this means that, faced with the prospect of selling shares, investors become emotionally affected by the price at which they purchased the shares. Consequently, they avoid selling to avoid the ‘regret’ of having made a bad investment decision.
Strangely, many people feel less embarrassed about losing money on a popular investment that half the world owns than about losing money on an unknown or unpopular share.
Time to build a financial plan based on reason
Considering all these psychological issues, how do you ensure you make the ‘right’ financial decisions?
That’s where your financial planner comes in. Building a financial plan is a great way to ensure that financial decisions are made from a logical point of view. A plan gives you a course to stick to, reducing the risk of making an impetuous decision that could harm your financial security.
Naturally, even a financial plan can be affected by bias and other psychological factors. So, working with a professional can give you another perspective and take the ‘emotion’ out of decisions.
When you want to make changes to your financial plan, a professional can help you to identify the reason behind this too. In some cases, updates are essential. However, there are occasions where the wish to make changes are driven by the factors above, and not based on the facts.
Get in touch
If you want to build a financial plan that helps you secure your future, please get in touch. Email firstname.lastname@example.org or call 01454 416 653.