We make thousands of decisions each day, and a lot of those decisions happen beyond our awareness. While plenty are minor or inconsequential — which socks we’ll wear, what we’ll have for lunch — the stakes are much higher when money is involved.
We spoke to Simon Russell, Founder and Director of Behavioural Finance Australia, about some of the ways that our unconscious mind might be calling the shots when it comes to investing.
What happens to our brains when we make decisions?
There’s a whole lot of research which shows that, at least in aggregate, at least some of the time, stuff is happening in our brains that we’re simply not aware of, and it’s actually these automatic, habitual processes that are guiding many of our decisions. These processes are normally quite helpful in our day-to-day lives — there’s a reason why we’ve evolved them, after all — but sometimes they go haywire. When that happens, it can generate what we call a bias.
The idea that we’re making decisions in a subconscious way might be hard to accept, but the fact that it doesn’t feel like it’s happening is actually a bias in itself — it’s called a blind spot bias. Maybe we can understand that other people operate this way, but acknowledging that we’re just as susceptible is a hard barrier to get past.
Loss aversion
By no means an uncommon instinct, loss aversion is when we feel the pain of a loss more than we feel the pleasure of an equivalent sized gain. Imagine it’s a windy day, you open up your wallet and a $50 note flies out and goes down a drain. For many people, the pain of losing $50 would be greater than the pleasure of finding $50.
While the extent of loss aversion will vary between people and across contexts, we can illustrate how we might feel by saying one gives us 50 units of pleasure while the other gives us 100 units of pain.
Some people will be much more loss averse than others. Say you presented a younger adult with an opportunity where there was a risk of losing $10,000. If that amount represents their entire life savings then they’ll probably be terrified at the prospect. But you might get a different response from a much more wealthy person whose investments go up or down by $10,000 every few days.
How can someone overcome the fear of losing money?
There are some strategies that don’t even require much of you. For example, when it comes to superannuation the less you look at it, the less sensitive you are to it. If you’re obsessively checking your super balance, it’ll feel like there’s a 50/50 chance that it will be up or down on any given day. And you’d be right — daily performance tends to hew quite close to this ratio.
But if we look at things over a longer period, it tends to become more weighted in favour of gains. So if you’re the type of person who feels losses more heavily than gains, you need to experience significantly more gains than losses to balance the emotional equation. Checking your balance less frequently can help with this.
The recency effect
The recency effect is the idea that we focus more heavily and more clearly on things that have happened recently. This is often quite useful in predicting things — if Usain Bolt was a fast runner yesterday, chances are he’ll be a fast runner tomorrow. The problem is when there are certain events that might be important or instructive, but because they’re beyond our ability to recall them, they cease to influence our expectations.
In the case of investing, looking at what’s happened recently can actually throw us off. There’s so much randomness and uncertainty swirling around in the moment, and we might be better served by making decisions with an eye towards the longer historical period instead. Yes, one particular asset class might have outperformed another last year, but let’s take a ten year view (or longer) and see what we can glean from that.
The familiarity effect
The familiarity effect is when we develop a preference for something merely because we’re familiar with it. There are strong investment parallels here. When choosing an asset class to invest in, are you basing it on a thorough assessment of all available options and their suitability given your risk tolerance, investment goals and time horizon? Or are you just going with what you’re familiar with?
Here’s where a degree of financial education might help. You don’t necessarily need to become an expert on investing; you just need to be familiar enough with an asset class that you no longer feel so uncomfortable dealing with it (assuming it suits your goals and circumstances).
Take the bias many people have against global equities compared to domestic ones (which is often referred to as home country bias). This might be countered by looking up international funds and checking their holdings for companies you recognise. Chances are there will be several names that are familiar to you. You might also be able to create familiarity by way of analogies. If someone is uncertain about how dividends work, having them likened to rent received from an investment property might help things click into place.
