Behavioral Finance – How we make decisions
Here we seek to explore and understand how we make decisions including investment decisions; not how we are expected to make decisions but our actual behavior.
Economic theory as given to us by Adam Smith, the father of modern Economics, assumes that we are rational beings meaning that we are risk- averse, self-interested and are keen to maximize our own personal benefits from the decisions we make. We are perfectly selfish; we will never concede anything for the benefit of others. We are also expected to have perfect knowledge and consider all available information in the decision making process.
Economic theory further assumes that we are perfectly rational, and are able to reason and make beneficial judgments at all times. In reality however, we are affected by human emotions such as fear, love, hate, pleasure and pain.
Based on our actual behavior, we exhibit actions that are not self-interested or risk averse. We do not have access to perfect information and may not process all available information. We buy rotary tickets which is a sign of risk seeking behavior; we participate in philanthropy and show kindness to others which shows that we are not self-interested.
Our rationality is influenced by our biases, which could be as a result of:
- Emotional errors or
- Errors in reasoning – reasoning based on faulty thinking.
EMOTIONAL ERRORS /BIASES
Emotional errors stem from impulse or intuition or reasoning influenced by feelings, they arise spontaneously as a result of attitudes and feelings that can cause our decisions to deviate from rational decisions and we end up making suboptimal decisions. These biases are:
This is a bias in which we demonstrate unwarranted faith in our own intuitive reasoning, judgments, and cognitive abilities. It may be result of overestimating knowledge levels and abilities.
For example; we are confident of our current financial situation, our earning capacity and the potential for it to increase. We therefore do not plan for eventualities such as loss of job, a medical situation that requires significant financial commitment or retirement.
This is a bias in which we fail to act in pursuit of our long term goals because of lack of self-discipline. We all have an inherent conflict between short term satisfaction and achievement of some long term goals. We know we need to save for retirement, but we have difficulty sacrificing present consumption because we lack self-control. We prefer small payoffs now compared to larger payoffs in the future. Sacrifices in the present require much greater payoffs in the future; otherwise we will not be willing to make current sacrifices. This behavior can lead to high short term satisfaction and a disastrous future.
Proper planning and having a budget will help us manage this bias. Adhering to a saving and investment plan is critical to long term financial success.
Status Quo Bias
This is a bias in which we do nothing “maintain the status quo” instead of making a change. We are generally more comfortable keeping things the same. Given a situation where one choice is the default choice, we generally retain that choice instead of making another choice. For example, if we are introduced to a certain investment when we started earning, we continue to deploy our extra cash to that investment without considering other higher return investments or changes in our life circumstances.
An initiative to review and analyse investment options in our decision making process is critical to overcoming this bias. Self-education to understand investment analysis would make it easier to consider other options.
Loss Aversion Bias
We strongly prefer avoiding losses as opposed to achieving gains. Losses are significantly more powerful than gains. When comparing absolute values, the value derived from a gain, is much lower than the value given up with an equivalent loss. We generally accept more risk to avoid losses than to achieve gains.
For an investor who has an investment that has lost value, loss aversion will make that investor to hold on to that investment even though there is no chance of the investment going back up. This is particularly applicable to shares.
This is called the disposition effect – the holding, not selling the investments that have experienced losses (losers) for too long and the selling of investments that have experienced gains (winners) too quickly.
A disciplined approach to investment decisions based on fundamental analysis is a good way to alleviate the impact of the loss aversion bias.
ERRORS IN REASONING
These are basic information processing or memory errors that cause our decisions to deviate from what may be considered rational decisions. Information Processing Bias – result in information being processed and used illogically or irrationally. Examples of these biases are:
Mental Accounting Bias
Here, we treat one sum of money differently from another based on which mental account we have assigned the money to, we categories our money in a number of non-interchangeable mental accounts. The mental accounts are based on arbitrary classifications such as source of the money e.g. salary, bonus, inheritance or gambling.
Have you noticed that amounts received as bonus or wins from gambling is easily used for leisure purposes, go on holiday, buy a gadget while salary is carefully planned for and invested?
Money is fungible i.e. interchangeable and therefore the financial decisions we make should not be based on the source of the funds to ensure we invest prudently. Our investment decision should not be driven by the source.
Under this bias, we take a heuristic i.e. rule of thumb or a mental short cut approach in decision making. For example the idea that comes to mind first is likely to be chosen as the correct idea.
In order to overcome this bias, we should carefully research and analyze the information we have before making decisions and specifically financial decisions.
Belief Perseverance Bias
These biases are due to mental discomfort that occurs when new information conflicts with previously held beliefs, as a result, we may notice only information of interest, ignore information that conflicts with existing beliefs or remember and consider only information that confirms existing beliefs, for example we were always taught that your home is your biggest asset, but is it?
Below are examples of belief perseverance bias:
It’s a bias in which we maintain our prior views and we inadequately incorporate new information. We overweigh initial beliefs and underreact to new information.
In our decision making process – we should always analyse new information and then respond appropriately. We should take the appropriate course of action even if it deviates from the course of action based on our previous beliefs.
It’s a bias in which we tend to look for and notice what confirms our beliefs and to ignore or undervalue what contradicts our beliefs. We convince ourselves of what we want to believe by putting more weight on information that supports our beliefs.
We should always actively seek out information that challenges our beliefs. The conscious effort to gather and process information that challenges our belief as well as positive information provides more complete information on which to base our decisions. The extra effort to gather complete information, positive and negative will likely result in better decisions.
Illusion of control bias
It’s a bias in which we tend to believe that we can control or influence outcomes when in fact we cannot.
We see past events as having been predictable and reasonable to expect. Outcomes that did occur are more readily evident than outcomes that didn’t occur. We tend to remember our own predictions of the future as more accurate than they actually were because we are biased by what actually happened. Since we don’t have perfect memory, when we look back, we tend to “fill in the gaps” with what we prefer to believe. In doing so, we prevent ourselves from learning from the past.
We should always ask whether we are being honest with ourselves about the mistakes we made in the past, and then learn from them. This is only possible if we revisit our past decisions.
Because cognitive errors stem from faulty reasoning, better information, education and advice can often correct for them hence moderate the impact of the bias in our decision making process.