Established financial theory also focuses on the trade-off between risk and return. The theory assumes that investors seek the highest return for the level of risk they are willing to bear. However, behavioural finance suggests investors are more sensitive to loss. For instance, most people require an even (50/50) chance of a gain of $2,500 in a gamble to offset an even chance of a loss of $1,000 before they find it attractive.1
The idea of loss aversion also includes the finding that investors try to avoid locking in a loss. Consider an investment bought for $1,000, which rises quickly to $1,500. We would be tempted to sell it to lock-in the profit. In contrast, if the investment dropped to $500, we would tend to hold it to avoid locking in the loss.
More generally, investors with losing positions show a strong desire to get back to break even – we are all victims of this. This means we show highly risk-averse behaviour when facing a profit (selling and locking in the sure gain) and more risk tolerant or risk seeking behaviour when facing a loss (continuing to hold the investment and hoping its price rises again).2
This is the flip side of overconfidence and causes us to make decisions in a way that allows us to avoid feeling emotional pain in the event of an adverse outcome.
Inertia is the inability to act, often even on things we want or have agreed to do. The human desire to avoid regret drives this behaviour.
Inertia can act as a barrier to effective financial planning, stopping us from saving and making necessary changes to our portfolios for instance. For example, if an investor is considering making a change to their portfolio, but lacks certainty about the merits of acting, the investor may decide to choose the most convenient path – wait and see. In this pattern of behaviour, so common in many aspects of our daily lives, the tendency to procrastinate dominates our financial decisions.
Your financial adviser is key to recognising when you might be suffering from inertia and can help you implement strategies to reduce the impact of this bias on your portfolio. This might include the automatic rebalancing of portfolios and dollar cost averaging for instance.
Many of these traits are human qualities that are not easily turned off. When it comes to money, we all have the tendency to behave irrationally at times - many of us will go to great lengths to rationalise our historical investment decisions, especially failed investment decisions. In extreme cases, this could lead us to continually delaying selling positions that are not generating adequate returns in the believe that one day they will ‘come right’.
For investors who tend to be overconfident, they believe they are better able to perform a certain action or task than they really are. For others, the fear of making a loss can lead to in-action when confronted with the potential for an investment to lose value.
These are not uncommon biases. We are unlikely to find a ‘cure’ for our biases, but if we are aware of our biases and their effect, we can possibly avoid the major pitfalls. Ben Franklin wrote in the 1769 Farmers’ Almanac, “there are three things extremely hard: steel, a diamond, and to know one’s self.” To make sound choices, you must know yourself to know what decisions your personality can withstand when building and implementing an investment policy and process.
Your financial adviser can help you to create a portfolio which reflects both your needs and personality. They will also work with you to determine your attitude to risk, and will consider issues such as investment time horizon and wealth level to establish your risk tolerance.
1 James Montier, Behavioural Finance, 2002.
2 Daniel Kahneman and Amos Tversky, ‘Prospect Theory: An analysis of decision making under risk’, Econometrica, 1979.
This article has been prepared by Godfrey Pembroke Limited ABN 23 002 336 254 AFSL 230690. Any advice provided is of a general nature only. It does not take into account your objectives, financial situation or needs. Please seek personal advice before making a decision about a financial product. Information in this article is current as at 4/02/2020. While care has been taken in the preparation of this article, no liability is accepted by Godfrey Pembroke Limited or its related entities, agents or employees for any loss arising from reliance on this article. Any opinions expressed constitute our views at the time of issue and are subject to change. Any tax information provided in this article is intended as a guide only. It is not intended to be a substitute for specialised tax advice. We recommend that you consult with a registered tax agent.