Unfortunately, for some of us, when making a decision that affects our short, medium or long-term financial wellbeing, a behaviour gap can arise between what we should do (rationally) and what we actually do (irrationally).
This behaviour gap can often occur when we allow our decision-making process to be influenced by one or more cognitive biases—systematic errors in reasoning, evaluating, remembering, or other cognitive processes.
Again, a systemic error can arise due to one or more factual and emotional reasons—too much information, not enough meaning, the need to act quickly, and the limits of memory.
Importantly, these reasons can often be brought to the forefront due to an overarching factor—a low level of financial literacy and capability.
Unfortunately, the level of financial literacy of Australians isn’t equally shared. Results from a recent HILDA survey highlighted women, and those aged 65 and over, generally have a lower level of financial literacy.
When looking at cognitive biases, some of the most well-known are optimism bias, loss aversion, recency bias, confirmation bias, and herding. When these (and other cognitive biases) are allowed to influence our decision-making, they can impact our ability to accumulate and preserve wealth over the short, medium and long-term.
For example, loss aversion is the tendency for some of us to prefer avoiding the pain of losses more than the reward of gains. From an investing perspective, when a rational analysis (and long-term view) may suggest otherwise, a loss-averse investor may be influenced to make one or more of the following decisions:
These examples, and others (eg investment option switching—think, as an example, changing risk profiles), can often occur during certain phases of an investment market cycle. Generally, an investment market cycle consists of four cyclical phases, and in the context of the share market, for example, are often illustrated as:
Regardless of whether the above examples (eg selling a high-quality investment that has incurred losses) occur in conjunction or in isolation, they have the potential to affect an investor’s long-term investment performance—and, by extension, their long-term financial wellbeing.
On this point, a research study was conducted on the investment switching behaviours of super fund members during a financial crisis. The research study covered investment switches across three COVID-19 time periods:
As highlighted by the paper published off the back of the research study findings*, the COVID-19 pandemic significantly impacted the Australian financial markets, for example:
With the above in mind, here are three high-level findings from the research study via way of analysis of over 42,000 single investment switch decisions made by super members from 1 January 2019 to 31 March 2021:
From these findings, the paper suggests the need for increasing financial literacy and capability levels, protecting super members (at times from themselves), and improving access to quality financial advice.
We often can’t completely remove cognitive biases from our decision-making. However, we can seek professional financial advice to become more aware of, and properly evaluate, the influence and effect they can have on us. This can be coupled with improving our financial literacy and capability, and implementing an appropriate and regularly reviewed financial plan, which can include:
If you have any queries about this article, please contact us.
*Griffith University and Iress. (2021). The wrong end of the switch.