Our emotions affect our investments and financial decision-making. From startup funding to savings management, it’s all about our believes and risk perception.
Investing is certainly an exciting activity, but what about that uncomfortable sensation about a risky business investment and the fear of losing our hard-earned savings?
Studies have shown that we suffer almost double losing $1 as we would feel pleasure gaining $1. Investing should be a rational act but emotions are what characterise us as human beings.
Emotions lead us to invest in startups in which we believe or towards investments we think could help us to diversify our portfolio. However, we cannot ignore that startup funding can be risky and that portfolios can be volatile as financial markets and the global economy are influenced by different variables. Recently, several political changes and security issues, such as Brexit and the twentieth century refugees’ crisis concerning Syria and Iraq, have increased economic insecurity.
Aside from market uncertainty and the risk that every investment carries with it, there are other factors that affect human behaviour when talking about investments and financial decision-making.
New Zealand’s Financial Market Authority (FMA) has released a white paper that provides insights into how consumers make choices, which can be used to shape regulation and inform market participants on how to develop and distribute their offerings.
“Around the world and in New Zealand, those involved in building financial capability are recognising the importance of understanding what drives consumers’ decision-making processes.” - Rob Everett, FMA Chief Executive
What are the main biases that affect our financial capability?
A) PREFERENCES
We tend to focus on what’s happening now, procrastinating and postponing tasks such as swapping to cheaper credit cards – this is known as present or status quo bias. People are reference dependent, meaning they assess the value of something according to a reference point. For example, we're reluctant to sell our homes for less than what we bought them for even if it was above the current market price. Loss aversion is another reason why people make poor financial decisions, due to our hard-wired fear of losses. We make irrational calls such as selling shares - simply because they’ve decreased in value – when we should be holding on to them.
B) BELIEFS
We are often overconfident of our own abilities and have unrealistic optimism. We also over extrapolate, making investments based on a small number of successful past experiences. Projection bias also exists due to our preference for focusing on the present and disregarding the future. It causes us to misjudge our future needs, leading to inadequate saving.
C) DECISION-MAKING
Our narrow-framing bias causes us to make financial decisions in isolation, rather than as inter-related pieces of a puzzle. This means that when we construct an investment portfolio, for example, we tend to assess each new investment on its own merits rather than as part of the whole portfolio.
We also adhere to rules-of-thumb, making us stick to familiar and simple strategies. For retirement planning, it might mean that we’d split our money equally between Kiwisaver accounts, which is a voluntary based savings scheme set up by the NZ government to help its citizens to save for their retirement, rather than choosing the most optimum balance.
D) SOCIAL FACTORS
The final aspect is to do with social factors: we often make decisions according to what those around are doing – our friends and family - and whether the salesperson is likeable. This makes objective, rational decision-making difficult.
How can we combat these biases?
It’s difficult and complex, however there are some examples of government and private-sector initiatives.
“By sharing our experience of using behavioural insights, we hope to be more effective in improving New Zealanders’ financial capability.” - FMA
In summary, we can use behavioural insights to give us an understanding of why people save inadequately, make uninformed decisions and find it difficult to choose financial products. Being aware of the natural biases that exist, and the strategies used to address them, may help you overcome the behavioural factors influencing your financial decision-making.