Renowned American investor and business magnate, Warren Buffett, once said: “If you cannot control your emotions, you cannot control your money”.
With Warren in mind, we’ve been looking at some of the negative behaviours that lead people to make poor financial decisions, and how best to keep those behaviours out of the equation when it comes to money matters.
Behavioural science suggests that the decisions we make when we’re in complex situations tend to be based on emotional bias, rather than completely rational assessment. In other words, we’re more likely to act on feelings instead of facts. When it comes to managing our finances, these emotionally-led decisions can have a seriously destructive effect on long-term wealth and wellbeing.
Three different types of ‘do-it-yourself’ investor
Why do we make bad financial decisions?
A survey carried out by insight agency Britain Thinks, on behalf of the Financial Conduct Authority (FCA), reported three different types of ‘do-it-yourself’ investor, and explained how each was in danger of making poor investment decisions. The three types were described as follows:
- Having a go: newer or less experienced investors who lack knowledge about investing and are keen to do it on their own. They usually conduct little research before making decisions and they can follow the crowd when choosing investments.
- Thinking it through: typically, these are either more experienced investors, or they come from a professional or academic background in maths, finance, economics or business. They often feel confident in their abilities to invest, but this can lead to overconfidence.
- The gambler: this group considers investing to be essentially placing a bet and they’re looking for the same kind of emotional thrill with their money. They are particularly attracted to shorter-term options that are high-risk but have the potential for high-return, including cryptocurrencies.
As the FCA rightly warns: “some consumers are making poor investment choices. In some instances, this may lead to consumers holding a lot of money in cash, missing out on potential investment returns. In others it may lead them to invest in high-risk products, which may not reflect their risk tolerance or their ability to afford the losses”.
People need expert, independent support to recognise their individual attitude to investing in order to make informed decisions with their money and avoid those behaviours that could leave them financially worse off.
Emotional investing
For example, emotional investing often leads people to invest at the wrong time, or to sell their investment when it would be wiser to hold on. These actions are based primarily on either the fear of loss, or the fear of missing out:
- Fear of loss: Studies have shown that some of us experience more pain when losing money, than pleasure gaining it. This ‘loss aversion’ might also cause an investor to sell their investment while stock markets are falling. However, this only results in them ‘crystallising’ their losses.
- Fear of missing out: Seeing others making large profits on an investment can cause some people to act rashly and invest without thinking through the wisdom of where they are putting their money, or fully understanding the risks involved.
Overconfidence
Overconfidence is another key contributor to bad financial decisions, and it’s something we all suffer from now and again. Ask most people if they are ‘better than average’ at driving, and they’ll say yes with some certainty (it’s the other road users who cause the accidents).
Similarly, investors often (mistakenly) believe they have more control over their investments than they actually do. This could lead them to overestimate their ability to identify the good investments from the poor ones, and lead them to become complacent or take bigger risks with their money than they can afford to.
For example, you might be tempted to think you’re an investment genius because of the stellar performance of your portfolio when, in reality, your investments have been doing well because so have all investments (what’s known as a ‘bull market’). But your portfolio may offer you too little protection against market drops or volatility during ‘bear markets’. Similarly, it’s common for some investors to feel unable to admit when they’ve made a mistake, holding onto poorly performing investments for too long, hoping for a recovery.
45% of investors were unaware that losing money was one of the risks associated with investing
Outcome bias
One of the most troubling statistics in the FCA report was that almost half (45%) of the investors surveyed were unaware that losing money was one of the risks associated with investing. This is surprising given that every piece of investment literature should come with the warning that ‘past performance is no guide to the future’, and that ‘capital is at risk’.
This shows how easy it is for investors to fall into the trap of ‘outcome bias’, which leads them to evaluate a decision based on the outcome of previous events. Mistakes that fall into this category include investing in last year’s highest returning fund or investing in a stock because it’s performed well for a friend. Relying on the past to do the hard work for you, instead of carrying out research and finding the right investment for the current market conditions, is an investment approach that’s likely to lead to a worse outcome over the longer term.
Amber River – helping you make better financial decisions
There’s very little we can do about our individual biases, apart from being aware of them and learning to control them, rather than have them control us. But when it comes to making financial decisions, it pays not to go it alone.
An Amber River independent financial planner can help take the emotion out of your financial decisions by gaining a deep understanding of your attitude to money. They will take the time to get to know you, your family, your circumstances and your ambitions in life. Only then can they create a well-balanced, diversified investment portfolio featuring a broad range of assets, built on the foundations of rational decision-making.
Get in touch
To speak to one of our team, arrange an appointment or find out more, call 0800 915 0000, or alternatively use our contact form here.
Disclaimer:
The information within this article was correct at the time of publishing, but laws and tax rules are subject to change. Your circumstances and where you live in the UK also have an impact on tax treatment.
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