3 ways behavioural science can help with your financial planning
When planning for your financial future, it is important to do so from an informed position. While working with a financial adviser is something everyone should consider, it doesn’t necessarily insulate you completely from how you might react to financial news. These reactions to financial news, positive and negative, fall under the field of behavioural economics.
As Dan Kemp from Morningstar Investment Management says: “Emotions play a huge role in financial planning. People often act against their long-term best interests.”
Whether people are paying more attention to recently received information, or valuing investments closer to home rather than those in other markets, investors are frequently using various aspects of behavioural science in their decision-making.
There are many aspects to behavioural economics, and in this article, we focus on three aspects that play a vital role in determining how we manage our financial lives and how working alongside a financial adviser could make a big difference.
Define a goal before you do anything else
Before we focus on how behavioural science can help with financial planning, it’s important to highlight how your planning should always start with defining a goal.
As our clients will attest, at Extended Investments Limited, we take an objectives-based approach to financial planning. That means building a financial plan, and implementing the associated recommendations, with your most important goals in mind. Many self-investors can struggle to articulate their goals, so, it is a good idea to really think about what you want to achieve and by when, so that you can devise a plan and define exactly what you need that plan to achieve. This is also an exercise in bringing together expectations (your goals) and what you can afford to accomplish.
When we discuss these types of behavioural economic factors that can influence your investment decision making, it is clarity of your objectives, and re-testing your plan and your investments against those goals that can ensure you remain on track and are not unduly influenced by these factors and other short-term noise.
1. “This time it’s different” – avoid the momentum investor bias
We have heard this many times across market cycles and it is always a valuable warning sign when someone utters the phrase “this time it’s different.”
When you hear this phrase, it is often a useful indicator that something is about to change about your investments and the markets. Whilst we don’t know what the markets may do from one day to the next, there is one certainty. That is, that if markets are going up, they will eventually turn and go down, and if they are going down, they will inevitably recover and go up. And, over time they increase in value, i.e. they go up more than they go down.
When markets are rising strongly, we often hear announcements of “this time it’s different” and that it will rise forever. Our advice is that this is a time for caution, don’t follow the trend. We have seen it in the tech bubble of 1999, through to the cryptocurrency spike in 2017, and the rise in Tesla shares in January 2020. Each time this comment is made, for us it is a sign that the market, or that investment, is at or near its peak in the current cycle. Markets never rise forever.
Similarly, they don’t fall forever. In the last three months we have seen financial markets, including stock markets and oil prices, drop precipitously. At their depths, we heard some market commentators despairing that this time it was different. In a falling market, this is an assurance. Because when you hear this, it is often a sign that the worst may be close to the end for now.
The big investor bias trap here is to follow the belief that “this time it’s different.” At either end of the cycle, it is typically wise to not go with what the herd is doing. When you hear this, do one of two things: keep doing what you have done for the long term, i.e. make no changes, or do the opposite of what the herd does.
2. Focus more on the future, not the past – avoid recency bias and hindsight bias
When investing, it’s easy to look to the past and not the future. Past performance is not something to ignore but it’s how you handle that information that is important. You may well have heard the oft stated line that all investment firms make, that “past performance is no guarantee of future performance.”
You only have to look at the chart below that presents the top asset class for each year and it is apparent that what is hot one year is likely not to be the next. Which is why you will also hear us say at Extended Investments Limited that we are not interested in chasing the next big thing, or the latest investment fad.
Perspective is important in volatile markets. For example, paying too much attention to how much your portfolio may have fallen may lead you to ignore the fact that you are still on target to reach your financial goals based on any long-term expectations (like we mentioned earlier) and your current risk profile.
Focusing too much on past performance, and less on how it is aligned to your financial expectations and plans, can have a significant effect on your how you respond and the decision you make, which can lead to you diverting from your long-term strategy. While all investment decisions are entirely based on your individual circumstances, often switching from your original plan on the basis of short-term market volatility may not be particularly beneficial to you.
That’s why working with a financial adviser could be something for you to consider. They will be there to offer advice, act as a sounding board, and help you avoid making knee-jerk decisions.
3. Ignore the “fight or flight” response to loss aversion
When investing in the stock market, a sudden shock can often prompt a fight, flight, or freeze response from investors. While these natural responses are common with humans in a variety of settings, fight or flight responses are poorly suited to investing in 2023.
Indeed, a report by Morgan Stanley suggests that investors often tend to make mistakes when they change portfolios based on a sudden downturn in performance.
Changing portfolios like this could often be down to “loss aversion”, a cognitive bias that details how the pain of losing is psychologically twice as powerful as the pleasure of gaining for many individuals. Investors that act on loss aversion biases will take actions with the intention of avoiding losses rather than, and sometimes at the cost of, generating gains.
Being aware of the loss aversion bias and ignoring your “fight or flight” response means you are more likely to stick to your financial plan and reach your goals as a result. Conversely, if you make changes based on frustration or a behavioural bias, you’re increasing your risk of losing out, either by selling at the wrong time or buying when the market is surging and just ahead of a correction. Remember these experiences can happen in both up and down markets.
This is why it’s important to speak with a financial adviser before making any investment decisions.
Working with a financial adviser could give you peace of mind
Working with a financial adviser could give you the peace of mind of knowing that you are well prepared for any market changes and that your plan remains aligned to your goals.
We are always available to act as a sounding board during your decision-making process and coach you through those decisions, utilising our market knowledge and experience.
We will also help you to avoid emotional or knee-jerk decisions that could otherwise hinder your progress towards your long-term goals.
Please contact us on info@extinvestments.com and we’d be happy to help.
Please note
Investments carry risk. The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
