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By Damon Sugden
In a perfect world, we would all make rational decisions when it comes to money, where every move is carefully analysed and underpinned by a clear understanding of what we want to achieve and what is required to get there. However, decisions are often clouded by emotions, biases and the ever-present hum of media noise.
The study of Behavioural Finance delves into the irrational side of financial decisions, in contrast to classical economics and the idea of “homo economicus” (the consistently rational human). This study confirms we are subject to conflicting emotions and errors in judgement, leading us far from the ‘do no wrong’ investor expectation set out by this elusive rational being.
A large portion of the population continue to run on auto pilot when it comes to financial choices, conducting little or no analysis when doing simple things, like paying off credit card balances. One observation found that when paying off multiple credit card balances, most would pay off the largest balance first, not the one with the highest interest rate, naturally costing more over time. But the emotional satisfaction of seeing the larger balance reduce was reported as most satisfying.
Our natural design is that our brains are hardwired to our emotional make up, we don’t think logically when it comes to money and investing. The pain of loss is a much more powerful emotion than experiencing a gain. We are often overconfident when transacting, or even prefer the status quo to avoid the pain of making a poor decision, perhaps missing out on the benefits that capital markets can provide over the longer term.
Although Behavioural Finance has gained more attention since the Global Financial Crisis and has the ability to define the conflicts we face in making financial decisions, it is unable to predict what markets will do, when bubbles will burst, if debt will instigate the next major meltdown or North Korea implode or Trump explode.
In absence of this we should focus on the elements of investing that can be controlled:
- Creating an investment plan to fit your needs and risk tolerance;
- Structuring a portfolio along the dimensions of expected returns;
- Diversifying broadly;
- Reducing expenses and turnover; and
- Minimising taxes.
Whilst we cannot ignore our emotions entirely – as they provide the ability to dream, yearn and set goals – we do need to limit negative emotional involvement in the implementation of a plan of action or investment strategy to achieve those goals. By embracing a set of guidelines to deal with whatever financial markets, and life in general, might throw at us we enhance the probability of making our goals a reality. These guidelines mean setting pre-agreed rules with your adviser, keeping you focused on your goals. Without these rules, you may be more likely to act on emotions triggered by the headline of the day, or water cooler chatter at the office.
Considering the technical and emotional minefield that investment markets hold, it might pay to speak to your adviser to review your current financial position, define your guidelines and create your rulebook. After all we are only human!
To establish your rulebook, contact Damon on 6163 6100 to discuss your options.
Damon Sugden is a Private Client Adviser with Capital Partners, helping individuals and families lead richer and happier lives.
4,707 total views, 2 views today
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