Thinking Long Term to Achieve Financial Goals
We originally published this article in Autumn 2023, however we wanted to draw your attention to it given the current market volatility. In particular, it reminds us that we should keep long-term investment goals in mind and avoid making rash decisions based on short-term market changes.
We all have tendencies and biases that creep into our everyday lives, these apply to the investment decisions we make too. Understanding behavioural biases can help investors make better investment decisions and avoid falling into some basic behavioural finance traps.
Over the past decade behavioural investing has become increasingly important. The concept gained prominence through the works of Daniel Kahneman (author of Thinking Fast and Slow) and Richard Thaler, winner of the 2018 Nobel Prize in economics and author of Nudge: improving decisions about health, wealth and happiness.
Understanding how personal behaviours can influence investment decisions can help your clients become a better investor.
One of the key differences between traditional economics and behavioural economics is a focus on the psychology of decision-making and the impact of behavioural biases.
What is behavioural bias?
When people make irrational decisions, it’s probably because of some human biases they have. These unconscious errors in our thinking can influence everything from the food we buy to the investments we make. Every day, behavioural bias has a huge impact in the world of finance. You might also hear it referred to as cognitive bias.
What is behavioural finance?
Behavioural finance is the idea that our biased behaviour can manifest itself in our financial decisions.
Our biases depend on several factors - like our tolerance for risk, when we need to see a return, and so on. The beliefs your clients have and the emotions they feel based on past experience will play a big role in the kind of investment decisions that they make.
For example, if markets took a sudden tumble, what might their instinct be? They might decide to stop investing until things calm down, or they could panic and start selling. They could also see it as a chance to buy stocks at lower prices. The market event is the same, but the behaviour depends on individual beliefs.
Understanding "Blink" and how it can hurt your client's pocket
Our brains make decisions in a world of limited and poor information. They are hard wired for quick pattern recognition and decisions made on the fly, referred to by experts as System 1 or "Blink". This has proved helpful for survival in the wild but is less useful in the world of investing. It can push us towards patterns that may not actually exist.
Five examples of behavioural biases in investment decision making
Investors should buy low and sell high. Why do they sometimes do the opposite?
1. Confirmation Bias
When we start researching potential investments, we’ve often already made our mind up about whether it’s ‘good’ or ‘bad’. Confirmation bias means we then naturally start to seek information that supports our existing conclusion, dismissing those sources that go against the beliefs we have. In a way, it’s overconfidence in the initial conclusion we made.
This investment bias can lead to investors making decisions that aren’t right, even when clear evidence has shown this. It can be difficult to overcome but trying to balance information is important, weighing up on its own merits rather than the fact it affirms beliefs. Having another person, such as you in your role as financial adviser, look at potential investments can help.
2. Information Bias
We’ve highlighted why looking at the information when investing is important above. But investors can have too much of a good thing.
In our modern lives, we are bombarded with information. Whether it’s in a newspaper, online or through social media, there’s a lot of information on investing out there. It can make it difficult to see the wood through the trees. This can make it challenging to understand what is relevant and irrelevant.
This is where your client’s financial plan can help. Having a clear set of goals and understanding why investment decisions have been made with these in mind can help them focus. Let’s say they’re investing for retirement that is 20 years away, the daily movements of the stock market is unlikely to have an impact on how they should invest.
3. Loss Aversion
Would you rather gain £1,000 or not lose £1,000? Research suggests that most people tend to strongly prefer avoiding losses than obtaining gains. This investment bias can create conflicts when it comes to making decisions.
We invest for the opportunity to generate returns, this always comes with some level of risk and there’s a chance values may fall. Loss aversion can mean your client doesn’t take the appropriate amount of risk for their circumstances and goals because they’re actively trying to avoid losses. On the flip side, some investors may resist selling assets that are down, even though it’s appropriate for them, due to the hope that they’ll make the money back.
Here it’s important to look at your client’s investment portfolio as a whole and why it’s been built in the way it has; to help them achieve long-term goals.
4. Anchoring Bias
Anchoring bias is a tendency to place too much importance on a particular past reference or piece of information when making a decision. When looking at this from an investment perspective, the most common thing to focus on is a share price. For example, investors may hold on to investments that have lost value because they’ve anchored the value of the asset to a previous stock price. Anchoring bias can skew your client’s perception of what investments are performing well for them.
Looking at the bigger picture and gathering information is important here, it can help create context around why an asset should be held or sold. Again, this should be done with your client’s wider financial plan in mind to help ensure their goals stay on track.
5. Bandwagon
We’ve all heard of jumping on the bandwagon, and it happens in investing too. If you’ve felt more comfortable in decisions because many other people have made the same choice, you may be affected by groupthink investment bias. It’s easy to see why it affects bias, after all, if everyone else is doing it, it must be ‘right’.
However, what your clients are investing for and their overall circumstances play a key role in building a suitable investment portfolio. You might speak to ten people who are all investing in a certain industry. But without knowing what their goals are and the context of their financial situation, it’s impossible to assess if following their lead would be right for a specific client.
How to avoid behavioural bias
We all have biases, but we don't need to act on them. By understanding what your client’s biases are, you can learn how to avoid them when making investment decisions. By following a robust long-term strategy instead of their unconscious whims, they’re more likely to achieve their financial goals.
Look at the bigger picture: The value of investments may have fallen sharply in the last few weeks. But when you look back over the entire investment period, clients have likely experienced gains overall. No one likes investment values falling but looking at the bigger picture can put them into perspective. If your client has invested recently, the falls can seem more severe, but they should still have time to benefit from future rises and recovery.
Manage how often you’re reviewing investments with clients: It can be tempting to look at investment performance frequently, especially during a period of volatility. But taking a step back and reviewing less often can help you focus on the long term.
Keep long-term goals in mind: When your client first invested it should have been with a long-term goal in mind. The reason we don’t invest for short periods is to hopefully smooth out the short-term volatility investments experience. Focus on these goals, which may still be years away.