In his well-known book The Chimp Paradox, Professor Steve Peters describes the primitive, powerful, and emotionally volatile ‘chimp’ that lives deep within each of us, causing us to act on impulse, contrary to reason and against our better judgement. Sigmund Freud referred to this part of our psyche as the ‘id’.
Regardless of what you call it, this animal spirit exists within each of us and it influences our financial decisions as readily as it influences other areas of our lives. Understanding the ways in which the heart can rule the head is the first step in lessening the likelihood of making a financial decision that you later come to regret. This article outlines a few common ways in which emotion can cloud judgement.
Mental accounting
Money is fungible: in other words, £20 is £20 whether you received it in your monthly pay packet, or in a birthday card from a relative. Despite this, many studies have observed that people often separate their wealth into imaginary pots based on miscellaneous, subjective and ultimately irrelevant criteria, and will spend money from one pot more freely than money from another.
This can become a costly practice: for example, people will hold on to a low interest savings account alongside high interest credit card debts. The sensible solution is often to use the savings to clear the debt and thereby pay less interest, but people are often reluctant to do so, particularly if those savings have been earmarked for something special.
Availability bias
This refers to the natural tendency to place more importance on new information versus old. Consider this: a person drives the same route to work every day in much the same manner. One day they witness a car accident on that route. For the next few weeks they drive with more care and attention than before, but they steadily revert to their old driving habits.
If all things are held equal in this scenario, then the risks of driving that route daily are unchanged from start to finish and, therefore, the temporary change in behaviour defies logic. This bias is present within all investors, so its cumulative effect could partly explain why market prices often overreact to news.
Loss aversion
Most people will act more quickly to prevent a loss than they will to exploit a gain. Numerous experiments have concluded that this is because most people feel the pain of a loss more keenly than the joy of a gain; the negative emotional experience is more intense than its positive equivalent.
The level of anguish differs for each of us, so this can be particularly problematic for less experienced investors who have not yet learned how they will react emotionally to a period of market volatility; some will experience a cool indifference, but others will endure sleepless nights.
Where investment decisions are being made, this pre-occupation with loss can also contribute to overreactions ‘en masse’. All investments fluctuate in value, so the decision of whether to continue to hold an investment should be based on a logical analysis of its prospects, rather than an emotional response to recent events.
And a few others…
Herding: mimicking the observed actions of those around you, for example, by selling an investment because everyone else seems to be selling it too (this behaviour is so regularly seen that investment strategies have been developed to try to exploit it).
The endowment effect: the belief that something is worth more than its true market value based on nothing more than the fact that you own it (often seen with houses).
Sentiment: holding on to investments because they were inherited from a family member, with no regard given to the fact that its fundamentals may have completely changed since the stock was picked.
Anchoring: an obsession with certain numbers on a performance scale, e.g. the FTSE 100 breaching 7,000, or a portfolio achieving 3% growth per annum. There is rarely any reason for selecting these benchmarks beyond the fact that they are nice round numbers, and yet investors will cling to them indefinitely regardless of the wider context.
Conclusion
This list is not exhaustive. There are many more ways in which biases, emotions and irrational thought processes can lead us to make questionable decisions regarding our finances. A detached observer may scoff at some of the behaviours described above, but with a little introspection, most would recognise at least one or two of these patterns in their own behaviour.
A good adviser will have experience in dealing with many different types of people. They will have witnessed and managed many situations where someone has been in danger of allowing their heart to rule their head, and often an impartial voice giving an experienced opinion from an outsider’s perspective may provide the moment of clarity required to avoid a poor decision.