The ancient philosopher Plato once said that “Human behaviour flows from three main sources; desire, emotion, and knowledge”. As it turns out, studies show what Plato theorised in 400 B.C.E. may prove to be true today. In this article, we look at wealth building behaviour and the habits that generate both success and failure.
A recent study by Baker and Ricciardi published in the Journal of Financial Planning (2015) found that when it comes to investing, we do little to get out of our own way and can be our worst enemy when it comes to managing personal finances.
Investing involves human behaviour including emotional processes, mental mistakes, and individual personality traits that serve to cloud our decision-making process. At SALA Financial services, we thought that it may be interesting to look at a few of the way in which we can all “get out of our own way” to become better investors.
Before you start, find your focus!
If you don’t know which way you are going, you can’t know where you are going to end up. One of the common traps that people find themselves in when it comes to investing is that they don’t have a focus or a goal in mind when they begin their journey. Goals should incorporate your values, needs, and wants.
Once you have a clear focus, it’s time to choose your path. Baker and Ricciardi establish that an investor can take one of two major paths to achieve their goals;
- Acquire the knowledge needed to do one’s financial planning and investing.
Benjamin Franklin was once quoted as saying, “An investment in knowledge pays the best interest”. We couldn’t agree more with this statement. Even people who choose to partner with a financial adviser owe it to themselves to ensure that their financial literacy is up to scratch so that they can take an active role in achieving their goals. Otherwise, the outcome that you receive when investing could be regrettable.
- Employ the Services of a financial planner or adviser.
Financial advisers already have the requisite knowledge, skills, and abilities to carry out important tasks on your behalf. Remember though, there’s a difference between knowing the path, and walking the path. Each journey involves trade-offs, but each offers the potential for long-term success. What is most important is that you make choices that are right for you.
Successful financial planning and investments are far more than number crunching, trading stocks, following the latest news and understanding the most recent market trends. Baker states that as much as people need to know about financial markets and investments, they also need to know about themselves. It is important that investors understand the psychology of financial planning and investing, to avoid being sucked in by the behaviour that often defies logic and reason.
Avoid the mental traps
Heuristics or rules of thumb – simple rules of thumb that involve a high degree of risk-taking behaviour and uncertainty. Heuristics are cognitive instruments that reducing time and effort in decision-making. Anyone who has ever been on a long road trip will know that sometimes what appears to be a short-cut can end up being the long way around.
Mental Accounting – a cognitive process in which individuals separate financial assets and liabilities into different groupings or mental accounts. For example, if an investment has a negative total return for the year, he or she may be tempted to use their cognitive decision-making process that focuses on the optimistic aspects of the investment, like the fact that the investment historically pays a healthy Mental accounting can be useful, but only when applied correctly and with rational to groups of assets.
Overconfidence versus status quo bias – overconfidence in one’s ability as a trader can result in high transaction costs and mediocre investment outcomes. On the other hand, some people may under manage their accounts, holding onto investments long after they should have been solved. One way to avoid these biases is to construct a well-diversified portfolio of managed investments, with a focus on reviewing your asset allocations annually.
Self–control bias– people often prefer to spend money today rather than saving for tomorrow. The high levels of consumer debt in Australia are one example of this. It is important to reset this thinking and look at investing as a future spending activity, rather than a chore that’s depriving you of enjoyment today.
A classic exercise that reveals the effects of Anchoring is the diamond ring anchor. Conventional wisdom dictates that an engagement ring should cost two months’ salary. This standard serves as one of the most illogical examples of anchoring, as the reference point (two months salary as a cost base for love) is a completely irrelevant standard created by the diamond and jewellery industry to maximise profits, and is not a real valuation of love. Many men cannot afford this standard and even go into debt to fund the purchase of a ring. Because jewellery purchases are a novel experience for most men, they are more likely to purchase a ring valued at an average price, rather than a fair price.
Given the natural human tendencies to fall into some of these traps, it is important to set up clear boundaries and policies about how you invest to keep yourself committed to a consistent and disciplined course of action. The purpose of this is to ensure that we avoid our own personal biases, and continue to follow a clear plan or course of action. Ignoring or failing to grasp this concept can be detrimental to your investment performance, and indeed may impact other areas of your life.
Final thought: Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.
Jason Zweig (Journalist, The Wall Street Journal; Intelligent Investor Column)
Baker, H. K., & Ricciardi, V., A.P.C. (2015). Understanding: Behavioural aspects of financial planning and investing. Journal of Financial Planning, 28(3), 22-26. Retrieved from https://goo.gl/QGvVdD