We are going to take a look at how you can guard against emotional mistakes and facilitate better investment decision making. But first – it should come as no surprise to learn that we humans are not always as rational as we think we are. Even when it comes to making those big and hugely important decisions about our money.
Theories of economics and what could be called ‘standard finance,’ all rely on one thing…people behaving rationally. And while you or I may have a fairly liberal definition of what is ‘rational’ – financial economists use a far more specific definition.
Economists such as Merton Miller and Franco Modigliani, identified that what they defined as a rational investor would “always prefer more wealth to less”. The rational investor never falls foul of cognitive and emotional errors, they claimed, and would never use a cognitive shortcut to get to a decision more quickly. Meaning every decision, a rational investor makes, is an intentional one, made only in order to reach the optimum level of benefit.
That all looks great on paper, but we know that these particular characteristics don’t exactly fit the profile of normal investors living in the real world. In fact, studies have continually shown repeated patterns of irrationality, inconsistency, even incompetence when participants are tasked to make decisions in uncertain or stress-induced conditions. Therefore, you could state quite categorically that the truly rational investor is somewhat of a myth.
Finance professor, Meir Statman states in his book, Behavioural Finance: “Normal investors are extremely susceptible to cognitive and emotional biases, and they care about more than just the (high-return, low-risk) benefits of investing.”
The question is, how do these biases and concerns affect normal investors decision making? One of the best and by far, simplest frameworks from behavioural science is that of dual-system thinking.
System 1 is our intuitive system. This is characterised by fast, automatic, emotional thinking. We don’t ponder, we do. Or rather, we react.
System 2 is our analytical system used for slow and logical thinking.
Often, we’ll find that System 1 guides us to make good choices and is more convenient – but it can also lead us down the wrong path. For example, when you get in the car and drive to work, you are mostly relying on System 1 (autopilot) and the outcome is good. When you see a market downturn, however, System 1 can jump to conclusions and bring about fear and panic which are sudden, emotional responses – emotions which can cause you to act irrationally and make you want to pull out and sell everything. It’s this kind of emotional bias that can cause investors to sell when the market is low and buy when the market is high, potentially leading to inferior, even dire results.
This is where System 2 kicks in.
As humans, we default to using as little brain power as possible on any given task, and is where System 1 excels, with its rapid thinking, shortcuts, and rule of thumb.
Sometimes however, we need to take time to reflect on the decisions we are making. So if you are choosing investments to fund your retirement years, you probably don’t want to rely on System 1. But what if your System 2 isn’t well equipped to make those decisions either? The answer to that question can be found in education and expert advice.
Examples of both systems modes of thinking when faced with market downturn.
System 1 – Thinking based on feelings of anxiety and despair:
- “Oh no, my portfolio has dropped in value. I knew I should never have invested. Maybe I should just get all of my money out now while I can?”
System 2 – Thinking based on taking the analytical and methodical approach:
- “Any market analysis will show that the value of my portfolio will fluctuate over the short term.”
- “It is only when I sell that I realise a loss, so it may be better to ride the wave, knowing that markets act cyclically, and ups and downs are to be expected.”
- “Since investing is a long-term strategy, what happens in the short and medium term is not altogether relevant, unless I urgently need cash.”
The role of a trusted adviser
Working with an experienced, knowledgeable financial adviser who has access to a wealth of market data and information, can help you build your financial plan intelligently and without the emotion attached. This is because your adviser will have learned – through years of hard work and effort – to use System 2. An investor who lacks the financial knowledge and experience of a professional are more likely to be misled by their brain’s default cognitive response and their heart’s emotional triggers.
When all’s said and done, the mind remains a complex and wonderfully mysterious thing. And you can’t take human behavioural elements out of an organisation completely. Nor would you want to. By simply understanding how our thinking systems work, we are then able to put the right processes in place for all of us to make better and more considered financial decisions.
If you’d like to find out more about how professional financial advice could help you, request a call back today, or simply complete our online contact form and one of our Wealth Managers will get in touch.