Three common financial errors and how to avoid them
If your house is on fire, what is the plan? Head for the exit, naturally. But if a market crash is burning a big hole in your investment portfolio, selling out may not be the best course of action.
The very same emotions and biases that can lead to good decisions in many areas of daily life can lead us astray in matters of money, experts say.
Behavioural economics, once a school of thought existing on the fringes of advice on spending, saving and investing, has moved into the mainstream. Nobel Prize winner Richard Thaler, co-author of Nudge: Improving decisions about health, wealth and happiness, is among those whose work is based on the link between psychology and financial behaviour.
His work adds to research that has been going on for decades that tries to unpick why investors are so prone to making mistakes such as selling low, when the price of a security they own has dropped and it panics them, or buying high, when they notice a security has become very popular.
“All of us are living in an environment to which we have not become adapted,” says Andrew Lo, professor of finance at MIT Sloan School of Management. “We are all products of human evolution, which tends to work over aeons. We are shaped by the environment we are put in, but when the environment changes so rapidly, we do not have time to adapt and our behaviour looks irrational.”
With the disappearance of defined benefit final salary pensions and their replacement with self-invested 401k retirement plans and money purchase schemes, Americans are being required to think about money and finances in ways they never have before.
“One of the most important evolutionary adaptations is the fight or flight response,” Prof Lo says. A financial threat and a physical one, however, are different things which require different responses.
“You are using the same response to a 20 per cent decline in the market or when you are threatened in a bar fight,” he says.
Chris Cordaro, chief investment officer at Regent Atlantic, a wealth manager, would agree. “The world is so complex that our brain has developed short-cuts along the way. Sometimes these lead us to the right decision, but often in financial or investment decisions it leads us astray,” he says.
Over the years, researchers have identified human biases and emotions that can lead to irrational financial responses. Here are three common money mistakes and ways to avoid them.
- Loss aversion
Research shows that many investors will try to avoid losses to a greater extent than they seek gains. According to Prof Lo, this trait can manifest in different ways including avoidance of investments that have downside risk, reluctance to sell a losing position and a tendency to become even more averse to loss after suffering a fall in value of an investment.
In extreme situations, loss aversion can lead people to hole up savings in low-interest accounts that may not leave them with enough money in retirement. The problem is that, in doing so, they are ignoring another risk — inflation. Its impact on a portfolio is easy to overlook because inflation tends to be a slow burn on wealth rather than a steep and sudden loss.
Experts say one solution is just to recognise the problem and seek advice from a professional financial planner. Another is to focus on low-cost index funds, but with the caveat that an index fund for the S&P 500 will still fall if the benchmark does.
The yang to loss aversion’s yin, overconfidence can lead people to take too much risk by seeking outsized returns and thinking they can beat the market.
“One extreme is to take too many risks and trade too actively,” says Terrance Odean, a finance professor at University of California Berkeley. “The other is to take no risk and stay on the sidelines.”
Mr Cordaro at Regent Atlantic thinks investors also tend to think they understand what the market is likely to do next.
“In the market, we believe we have a much greater ability to predict what is going to happen than we actually do. People trying to time the market has probably destroyed more wealth than any other bias we have.”
The best course is the middle ground — a diversified portfolio based on retirement age that is rebalanced perhaps once a year.
Another reason why some people may be lured to the latest, and often highly volatile, fashionable investment is just the thrill of it. If that is the case, it is best to keep any gambling at the Wall Street casino to an amount that can be lost without hardship.
“It is likely the two aren’t exclusive,” Prof Odean says. “You can be overconfident and to some extent entertaining yourself. If it is your retirement money, you shouldn’t be doing it, but if it is a smaller sum, it probably is not that big of a deal.”
- Mental accounting
Coined by Prof Thaler, mental accounting refers to how people evaluate their finances depending on the money’s source (is it from an inheritance, a pay cheque or a credit card?) and its intended use — (for example, new clothes, a holiday or an investment). Instead of thinking about the bottom line, as an accountant would in a formal set of accounts, Prof Thaler has argued that people see money as relative to its origin and purpose.
Even seasoned investors are guilty of what gamblers call “house money” — thinking of investment gains as “disposable income”, Prof Thaler argued in his academic paper, and are more likely to use those gains on risky investments.
On the spending side, there is the “Starbucks effect”, says Mr Cordaro. “You will spend $5 a day at Starbucks as a little indulgence,” he says. “What is the impact on the whole budget?”
A better way to decide whether you can afford daily coffee treats is to add up the costs of those Starbucks visits over a whole month and plan your next month’s budget accordingly.