Why is it so hard to fix our mistakes? Sometimes, decisions are not black and white – especially when it comes to our finances. We have many decisions to make when it comes to our financial future – but we get things wrong sometimes. The second part of our ‘biases’ mini-series explores our mistakes and why they can be hard to fix.
There are many psychological vices that hinder our decision-making. One of them is loss aversion, which is the fact that we feel loss more than we feel gain. For example, it is a good feeling when your superannuation balance goes from $500,000 to $600,000. But watching that same $500,000 drop to $400,000 seems unbearable. It’s the same amount of money, but it feels worse to lose it.
In financial situations, sometimes we need to put up with short-term pain for a long-term gain. In March 2020 there was a 37% drop in the sharemarket due to the COVID-19 pandemic. Many people panicked at the drop and sold good quality shares for 70 or 75 cents on the dollar. They simply couldn’t cope with the short-term loss. In regards to investing, though, the job of that money is to earn you enough to live off in your retirement – and with that we need to have an acceptance that it involves some volatility.
Sometimes, it can be difficult having a positive outlook over a negative one when so many negatives surround us; including the daily news.
The second vice is the endowment effect – that we often believe our assets are worth more than what they actually are – for example, property. We might think that a property we own is worth more than it is, especially when compared to what’s available on the market at the time. We sometimes have an inflated view of the value of our assets.
The third vice, which is somewhat related to the endowment effect, is anchoring bias. That is when people stick to a dollar amount regardless of the asset’s real value. As an example, if you ask someone what their house is worth, they’ll often say the amount they paid for it. But that’s not the same as its current value. Someone who bought a house for $400,000 would struggle to sell it for $380,000 because they’ll see it as a loss. A few years down the track they might sell it for $401,000 and see it as making a profit. But in the meantime, the costs of owning that property, such as maintenance, would well and truly outweigh that tiny profit.
People can get anchored on other dollar amounts, too – such as their superannuation and the figure they want it to get to. But values change, circumstances change, goals change – and that final figure will need to change, too. And it can be hard for people to accept that.
Opportunity cost is another risk associated with anchoring bias. While taking less money for an asset is simply seen as a loss, what should really be considered are the missed opportunities of not receiving that money at all. For instance, in the house example above, if the person waits for years to sell that house for what they perceive as a ‘profit’, the money they are holding onto – or putting into the house in the meantime, could be much better off invested somewhere else.
We also have status quo bias, which is keeping things the way they are. People tend to stick to a strategy they are used to, even if it’s not the right fit for them now. They don’t make financial decisions based on the outcome or based on what’s best for them at present, but rather, they stick to a strategy they already feel comfortable with.
Another bias is the sunk cost bias, which is where we act against our best interest based on a decision we’ve made in the past. For example, we let a decision we made 5 years ago affect our current ones – whether that decision was right or not. But the fact is, that decision doesn’t matter right now. We need to forget these past decisions and what they may have cost us; and look at the present situation instead. Michael will argue that the best examples of sunk cost bias are seen in bad rom com movies, where the guy is a total loser, but the girl has spent (wasted) 5 years of her life with him, putting lots of effort into the relationship. And even though he’s not the right guy for her anymore, she can’t get past the time and energy she has already invested in him. Sadly, the fact is that in any example of sunk cost bias, that time and money is long gone. This bias is a particularly hard one to get around. We see it often in examples of property – people invest lots of money into a house, but it never gets to the value that they want it to be, or costs them more than they expect. And then they find it difficult to sell the house due to all the time, energy and money they invested into it.
The final bias is the familiarity bias, which is similar to the status quo bias. It’s where we prefer things that we are familiar with. For example, people will have biases towards companies in their own country. Australians tend to only invest in Australian brands, because they know them and they are familiar. People will buy homes in the same street so they can live in one and rent out the other. But the problem with this is that if something drops the value of your home (such as a big construction project), it’ll also drop the value of your rental down the road. It’s best to diversify and buy in another area. Familiarity bias often lends itself to under-diversification of investments.
What can we do about these biases?
If you would like personalised assistance with those questions, give us a call at 07 4772 0938
Listen to the related podcast!
In financial situations, sometimes we need to put up with short-term pain for a long-term gain. In March 2020 there was a 37% drop in the sharemarket due to the COVID-19 pandemic. Many people panicked at the drop and sold good quality shares for 70 or 75 cents on the dollar. They simply couldn’t cope with the short-term loss. In regards to investing, though, the job of that money is to earn you enough to live off in your retirement – and with that we need to have an acceptance that it involves some volatility.
Sometimes, it can be difficult having a positive outlook over a negative one when so many negatives surround us; including the daily news.
The second vice is the endowment effect – that we often believe our assets are worth more than what they actually are – for example, property. We might think that a property we own is worth more than it is, especially when compared to what’s available on the market at the time. We sometimes have an inflated view of the value of our assets.
The third vice, which is somewhat related to the endowment effect, is anchoring bias. That is when people stick to a dollar amount regardless of the asset’s real value. As an example, if you ask someone what their house is worth, they’ll often say the amount they paid for it. But that’s not the same as its current value. Someone who bought a house for $400,000 would struggle to sell it for $380,000 because they’ll see it as a loss. A few years down the track they might sell it for $401,000 and see it as making a profit. But in the meantime, the costs of owning that property, such as maintenance, would well and truly outweigh that tiny profit.
People can get anchored on other dollar amounts, too – such as their superannuation and the figure they want it to get to. But values change, circumstances change, goals change – and that final figure will need to change, too. And it can be hard for people to accept that.
Opportunity cost is another risk associated with anchoring bias. While taking less money for an asset is simply seen as a loss, what should really be considered are the missed opportunities of not receiving that money at all. For instance, in the house example above, if the person waits for years to sell that house for what they perceive as a ‘profit’, the money they are holding onto – or putting into the house in the meantime, could be much better off invested somewhere else.
We also have status quo bias, which is keeping things the way they are. People tend to stick to a strategy they are used to, even if it’s not the right fit for them now. They don’t make financial decisions based on the outcome or based on what’s best for them at present, but rather, they stick to a strategy they already feel comfortable with.
Another bias is the sunk cost bias, which is where we act against our best interest based on a decision we’ve made in the past. For example, we let a decision we made 5 years ago affect our current ones – whether that decision was right or not. But the fact is, that decision doesn’t matter right now. We need to forget these past decisions and what they may have cost us; and look at the present situation instead. Michael will argue that the best examples of sunk cost bias are seen in bad rom com movies, where the guy is a total loser, but the girl has spent (wasted) 5 years of her life with him, putting lots of effort into the relationship. And even though he’s not the right guy for her anymore, she can’t get past the time and energy she has already invested in him. Sadly, the fact is that in any example of sunk cost bias, that time and money is long gone. This bias is a particularly hard one to get around. We see it often in examples of property – people invest lots of money into a house, but it never gets to the value that they want it to be, or costs them more than they expect. And then they find it difficult to sell the house due to all the time, energy and money they invested into it.
The final bias is the familiarity bias, which is similar to the status quo bias. It’s where we prefer things that we are familiar with. For example, people will have biases towards companies in their own country. Australians tend to only invest in Australian brands, because they know them and they are familiar. People will buy homes in the same street so they can live in one and rent out the other. But the problem with this is that if something drops the value of your home (such as a big construction project), it’ll also drop the value of your rental down the road. It’s best to diversify and buy in another area. Familiarity bias often lends itself to under-diversification of investments.
What can we do about these biases?
- Treat your investments as if they were someone else’s and you were just looking at them for the first time. What would you do as an outsider? Try to take away the subjectivity.
- When it comes to an asset, think about it as though it were a new one, or an investment – that is, what is it worth now, and if you were making a decision for the first time, would you buy or sell it now? If you knew what you know now, would you still do the same thing? That is, would you still purchase the asset? Do the same investments still suit your needs right now?
If you would like personalised assistance with those questions, give us a call at 07 4772 0938
Listen to the related podcast!
Share
