Behavioural Biases

From everyone here at GPFM, we hope you are well. As a team we want to offer our congratulations to everyone for staying at home where possible and suffering this ‘short-term discomfort’ to achieve all of our various longer-term goals.

In the current climate, we thought it would be useful to our clients to compile some information on Behavioural Biases and how they can impact financial plans and investor decisions. It is a subject that we advisers spend a lot of time researching and is one of the reasons we ask you lots of questions about your experiences with money and what you want it to achieve for you. How people react during turbulent market conditions can have a major positive or negative impact on their overall financial plan.

Amid the current global crisis and market downturn, often our clients will be looking to us advisers as a shortcut to rationality. You probably just want all this to end; the uncertainty concerning the risks to health, the uncertainty regarding plans made and the uncertain impact on our daily lives. There is also constant coverage from the financial media with their reports of large falls and recoveries that add to our sense of panic.

When it comes to our investments, many of us have been here before and it is worth reminding ourselves of that fact. But sometimes reminding ourselves may not be enough. Our rational self, who tell us how we should behave, differs greatly from our emotional self, who tells how we want to behave or actually do behave.

As individuals we are faced with hundreds of decisions every day and we cannot be fully informed about all of them. We make assumptions and take mental shortcuts, otherwise we wouldn’t get from under the bed sheets in the morning and, even if we wanted to be fully informed, we are wired to avoid that effortful cognitive activity.

We act and react instinctively and emotionally. If you are standing in front of a bear trying to rationally calculate whether the blow of its paw is strong enough to kill you, then you are already dead. We have fight or flight responses and while these have been helpful in getting us to the top of the food chain, they are not always helpful when facing financial issues in the 21st century. As investors we may feel we just want to flee, we just want it to stop, we just want to get out of there, maybe sell everything and make it all go away. We may feel that we’re standing in front of the financial bear.

It is our role as advisers to ensure you just stop and think. Many clients need advisers to help them not behave in a way that their future selves come to regret. When situations are framed in terms of gains, we tend to be risk seekers and when they are framed in terms of losses, we are risk avoiders. This will influence investors to buy high, when all the headlines and conversations are optimistic and sell low when they are pessimistic. This is of course irrational as losses are crystallised and investments purchased at higher prices. This graph shows an example of the emotions we experience during market volatility.

We frame our gains and losses from the reference point of what we currently have and we feel the pain of loss more intensely than we appreciate the pleasure of gains. It’s likely that you feel more pain to see your portfolio valuation fall than the pleasure you would feel to see an equivalent rise.

This is where we want to reiterate to you the importance that you stay invested throughout this volatility. As you know, during our reviews and conversations, our advisers always refer back to your original goals, timelines, objectives and the purpose behind your investing in the first place. It is important to think of those rather than look at the latest headlines.

The different outcomes we experience from decisions we make based on the timeframe we use is a fascinating subject. It is our loss aversion combined with short term panic reactions that can lead to behaviours that are the most detrimental to investors. Looking at a relatively small part of the investment journey does not really help. This combination of aversion to loss and short-term panic reactions can lead to poor outcomes.

Now is the time to focus on your longer-term goals and objectives. Remember why you are invested in the first place and try to drown out the ‘negative noise’ that surrounds us in the present. Periods of volatility and market crashes come and go as evidenced in the attached chart. Successful investors avoid panic reactions and put to one side those negative emotions that can often lead us astray and make us behave outside of our financial plans.

We hope you find this informative and that it helps you to understand investment markets and strategy during these volatile times.