Many factors can influence the financial decisions we make. And even aftercareful and rational analysis, certain ingrained psychological traits will have an impact on our investment choices. Here are the key lessons of behavioural finance, as well as some important reflexes you can develop to sharpen your skills as an investor.
“For a long time, economic theory suggested that decision-making outside the personal sphere was done in a rational manner, based on analysis and the information available,” explains Richard Guay, a Finance professor at the Université du Québec à Montréal (UQAM) and a specialist in behavioural finance. “However, we now have a better understanding of how people behave: Even in the financial field, decisions aren’t always made calmly and coolly, and they aren’t always rational.”
Insecurity, fear of loss, risk aversion, excessive optimism, trauma tied to one’s personal past… all of these biases can play a role when it comes to choosing an investment or a financial vehicle. “Our perceptions are coloured and informed by what we’ve experienced, and by a fundamental part of what makes us tick: our fears,” says behavioural finance expert Josée Blondin, a psychologist and the founder of Intersources, a consulting firm that specializes in issues of organizational psychology and development.
Emotions are often the source of poor decision-making because they can get in the way of an objective analysis of the situation at hand. A typical example of this is when panicky investors jump the gun and sell a stock that has been falling recently instead of taking the time to clearly analyze the situation and see how it’s evolving.
At the other end of the scale, inertia can be the undoing of investors who prefer to patiently wait for a hypothetical market rebound. “Loss aversion is one of the most common biases. Some people are very hesitant to sell a stock, even though it’s falling quickly. They focus on the immediate loss rather than on what their ultimate loss will be if they end up selling once it’s fallen even further. So long as the stock hasn’t been sold, the loss is only theoretical, which gives them a false sense of security,” says Guay.
Overconfidence is another common bias. “This comes into play when people are so confident in their judgment that they improperly evaluate risk. They might place their entire savings in a single security because they’re convinced it will provide good returns, without taking into account the threats that such a strategy poses. Even when presented with sound objective arguments, they tend not to change their minds, and sometimes stubbornly go ahead with a poor decision,” explains Guay.
Cognitive biases are another category of factors that influence decision-making. These biases have a greater hold on investors who are less skilled in the financial field and related disciplines (such as mathematics). “A good analogy would be someone playing roulette who might want to bet on red because it’s come up the last 10 times and he sees a trend there. With an understanding of the laws of probability, that person would make a different decision,” says Guay.
The types of automatic responses that most humans have can also combine with various emotions to cloud an investor’s sense of judgment. Mimicry and herd behaviour are two of the most common biases. “It takes courage and a certain self-confidence to go off the beaten path when it comes to making financial decisions,” says Blondin. Most of the time, human beings prefer to move in the same direction as everyone else. It’s more reassuring that way, but it’s not always a winning formula.
All these biases have an impact on the financial decisions we make, even though we might not be conscious of them. “Of all the biases, the emotional ones are the most difficult to avoid,” says Guay. But it’s still possible to make rational choices and reduce the risk of mistakes. Here are five useful reflexes to develop:
“Before you make a financial decision, it’s best to give yourself some time, and then, once you’ve made your decision, you need to let go: We have no control over the market or the economy, so we can’t predict what will happen,” explains Blondin. This timeout, even if it’s only a brief one, “allows your power of reasoning to do its work. Taking your time will lessen the effect of emotions on your decision,” says Guay.
Even though it’s impossible to use reason alone for all our decisions, having a good sense of who we are can help to reduce the negative effects of emotions. “Taking a good look at yourself and learning from your mistakes can lead to making better decisions in the future Learning to know yourself, setting life goals and keeping track of your progress can help you make better choices based on your personal expectations’’ recommends Blondin.
Using objective data to guide your decisions is still the most effective way to stay as rational as possible and lessen the impact of emotions. Keeping up on market trends, maintaining a balanced portfolio, casting a critical eye on mass movements, analyzing results by sector and by company, following the financial markets and being on the lookout for pertinent information are key habits to develop. “To make enlightened choices, you need to develop intellectual curiosity,” insists Blondin.
A good way to counterbalance your own subjectivity is to talk to other people. “The mere fact of asking questions forces us to engage our power of reasoning. Having to build an argument to explain our point of view allows the cognitive side to take over,” says Guay.
Given that nobody can ever be completely rational, forewarned is forearmed. So, in addition to applying the previous advice, “diversify your portfolio”, insists Guay. If you make a mistake, the losses will be less severe.
Knowing the basics of financial behaviour and its teachings is essential for anyone looking to gain a better understanding of their own financial choices. This can also improve the decision-making process and reduce the risk of errors caused by the sway of emotions or cognitive biases.
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