When it comes to the area of managing our wealth, we like to believe that we can make rational decisions for our financial well being. This belief is contrary to what actually happens from extensive research done in the area of behavioral finance. Here are three common behaviours documented by research- ers where our human intuition undermines our financial well being.
This is a mental short cut we use for self preservation. On a fundamental level, it makes sense to avoid loss in the material world. However, when investing in the financial markets this intuition plays havoc with us.
Imagine investing RM10,000 in shares of a large corporation. You are told this company is well run and has good prospects over the next five years. You bought into the share yesterday at RM5 per share. One month down the road, a financial crisis in Europe causes stock markets worldwide to plunge. Your shares fell by more than half to RM2.20
You panicked and decide to limit further losses by selling all your shares. By the end of the year, the share price of the company has risen to RM7.80 At that point, you felt the loss of missing out on the RM2.80 you could have gained had you stayed put during the European financial crisis.
So, you decided to buy the shares again. Rationally, you knew that to make money in shares, you should buy low and sell high. However, due to loss aversion, which is a built-in intuition, you end up buying high and selling low, thereby undermining your financial well being.
Assume now that you never took your stockbroker’s advice to invest in the shares of the large corporation but instead left it in a fixed deposit account. You justified to yourself that you are not prepared to take the risk of losing your hard earned RM10,000 (loss aversion). Furthermore, every month when you renew your fixed deposit you could see the money growing by say 0.25%. Your money would have grown by 3% at the end of the one year. You feel satisfied to see your money grow without any hiccups.
Unfortunately, this is a money illusion as you concentrated on the face value of the money instead of actual value of the money in terms of purchasing power. In fact, if inflation were growing at just 5% per year, you would be losing your purchasing power by 2% a year when keeping your money in a fixed deposit account.
Mitigating the Effects of Behavioral Finance The first step is to recognise the existence of faulty intuition. The second step is to think about the possible pitfalls you may encounter in your investment journey. The third step is to have a robust process of managing your finances. Having a process is crucial because it sets out the ground rules of how you should behave when those pitfalls that could trigger your faulty intuition appear.
Finally, engage the services of a qualified financial adviser who has lived and survived through market cycles and is unfazed by market volatility. He can help you craft that investment process to ride out the market cycles as your investment eventually grows for your future needs.