Behavioural Finance: Why we do what we do with money.
Have you ever made a very short-term, impulsive decision and then found you regretted it a day or two later? Of course, you have; my partner and I do it each time we visit K-Mart.
In the world of finance and share trading, psychological influences, emotions and biases affect our behaviour, and this behaviour is not often rational or logical. This is called behavioural finance and is a very popular topic in the finance world currently. Behavioural finance indicates that emotionally charged and irrational investment decisions are made without consideration to any monetary theory or financial analysis.
During COVID-19, sharemarkets around the world dropped by unprecedented amounts. There was obvious angst and an element of the unknown in respect to the world economy and just how significant an effect COVID would have across the globe.
As a result, people reacted to the fear and anxiety and made emotionally charged decisions to sell out of their share portfolios or superannuation accounts, without giving serious thought to the long-term consequences this behaviour would bring. Humans have a natural psychological make up to protect and survive, which transcends to our finances.
There are numerous reasons why people make irrational decisions with their money, or invest the way they do. One is confirmation bias. This is a mental belief or opinion someone holds where they already firmly believe something to be true, and try and find information and proof that supports this theory. They deliberately fail to look for any evidence to the contrary in a bid to convince themselves their idea is the best one and there are no suitable alternatives. With investing, this bias is riddled with risks as there are always alternative options and things to be wary of. Confirmation bias can lead to investors making an irrational decision to buy a stock at the wrong time, or sell a stock prematurely, if they have a pre-perceived idea that there are better options out there, without conducting their due diligence.
Another mental bias that is very topical at present and is somewhat less scientific than most, is what is known as FOMO, or a fear of missing out. This bias sees people watching a certain stock or asset class continually increase in value regardless of the reason, and believe they need to buy into it as soon as possible in an attempt to not miss out on the potential gains on offer. One of the most effective biases out there, the more people that buy in due to FOMO, are actually magnifying the issue at hand. FOMO makes people make irrational decisions that are purely focused on the short term, and these decisions tend to go against any long-term strategy and end up costing money rather than making it.
Two good examples of this are Afterpay and Bitcoin. Both are assets out there that have no doubt made a lot of people a lot of money. However, most financial analysis out there suggests neither asset should have performed as it has based on the profitability of the asset overall. People experiencing FOMO have driven up the prices of these assets, and at times, these people have been burned by profit takers who sell large stakes and cause the price to plummet. At the time of writing, Afterpay is trading at around $105, which is down from its peak of around $159 earlier this year, and up from its COVID bottom of around $8. What is fascinating, and also alarming from my point of view, is that the company is yet to post a profit. The share price performance has almost purely been driven by people making irrational, short term decisions by reacting to the FOMO they feel.
As a financial planner, I believe one of my main purposes is to coach and hold my clients accountable for their decision making and to make sure my clients know exactly why they are investing the way they are. We recommend our clients invest their money in certain ways based on numerous factors, one of which is sound financial analysis and research. We ensure our clients do not make short-sighted decisions influenced by emotions or FOMO, and help them with their self-control. The qualitative factors that influence financial decision making can be just as, if not more, important than the quantitative factors. Clients of financial planners tend to not suffer losses based on qualitative reasons and do not invest with their emotions. If this kind of financial future sounds appealing to you, please do not hesitate reaching out.
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