To understand why, and to manage ourselves better, we need to look at both the rational and emotional parts of the brain.
Latest research suggests that both the rational and emotional parts of the brain work together when making decisions, including investment decisions.
After the cerebral cortex has weighed up the facts, the decision is finally made in the emotional core of the brain, proving that making ‘rational’ investment decisions is far more complex than previously thought.
Our emotions affect how we behave as investors and this can affect the subsequent return that we get.
Human beings form established patterns of thinking, known as heuristics, in order to make decisions more efficiently. These are rules that serve as shortcuts in our minds. Think about the route you take to work: it is automatic and not something you think about much.
But biases can pose a problem when applied inappropriately. In an investment context, biases can prove disastrous. Consider over-optimism when investing, which assumes that bad things happen to others, not to me. Or loss aversion, where you put off investing because you are afraid of realising a loss.
Other common biases are anchoring, where investors relate decisions to whatever they see as familiar, even arbitrarily so, and herding, where investors blindly follow others instead of using their own judgement.
Before making a decision, you need to understand why you want to invest, on an emotional level. There are usually competing emotional benefits for an investment. For example, if the investment works out, you will feel successful and happy that you can provide for your family. However, you also want to feel safe and if the investment is too risky you may not.
By identifying what is driving your investment decision, you are more likely to understand how best to meet those needs, without negatively affecting your investment return.
Let’s look at an example of a man who is facing retirement and needs to make important decisions regarding his savings.
Some of the biases he is likely to encounter are loss aversion, the fear of losing his hard-earned life savings, and anchoring to the familiar concept of becoming more prudent or cautious as he ages, which makes him identify himself as a prudent investor. Another bias he will probably struggle with is mental accounting, which is defined as compensating for too much risk in one area by not taking enough risk in another.
For this investor, the transition from being a salaried worker to a retired individual may be very scary. He may be experiencing such intense loss aversion that when it comes to his retirement savings, he does not want to take any risk at all. He may want to stick to stable investments, which will not yield the kind of returns he needs to keep pace with inflation. The above, combined with a loss of income and underestimating our longevity makes us invest too conservatively.
The first step to overcoming biases is to be aware of what they are and then find a way to mitigate them.
You need to understand not only your preferences and your priorities, but also your emotional drivers. We are all emotional creatures and we cannot avoid that. But if you know what your emotional drivers are, you can do something about them. Putting guardrails in place will help to ensure that when faced with investment decisions, you do things differently.
However, for many of us this may be easier said than done.