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Introduction

The core of behavioural finance is how irrational or illogical factors affect your financial decision making. You need to be aware of these irrational or emotional mistakes and be able to identify when you are about to make them so that you can take remedial action.

Some participants in the financial services industry believe that in order to comply with the Financial Advisory and Intermediary Services (‘FAIS’) Act, the only requirements are that they fill in a form, tick the relevant boxes, do a risk analysis and make the correct investment choice.

It is not that simple. To avoid misunderstanding your investment needs and decisions, your financial adviser needs to consider your psychology as well.

Key influences

Your cognitive and emotional state and social environment influence both the way you think and your personality. Behavioural finance is not about how you should act but rather about how you do act. Your actions are not always rational. The brain is wired like a computer and you rely on certain triggers from your environment to access certain information.

First, you make your decisions either intuitively or by logic and reasoning. In daily activity, most decisions are made intuitively as you do not stop and think before every action that you take.

However, using logic does not always lead you to the correct decision. You need experience and knowledge as well as time to make a good decision. For example, if you are in a good mood, you tend to make less rational decisions that are based on the "high" that you feel. Other emotions such as anger, pride, regret, joy and envy can, therefore, be a major factor when you make your financial decisions.

You should therefore train yourself to rely less on your emotions when you make financial decisions. This however is not always easy as an individual’s emotions serve to protect their self-esteem and emotional well-being.

Social influences such as peer- group pressure can lead you to follow advice from "investment conversations". The golden rule when you are listening to these conversations around the braai or in other casual environments is that if people mention unrealistic guaranteed returns of 30 percent or more, you should avoid following that advice. Such returns are generally too good to be true and could lead to disappointment or even financial ruin at a later stage.

Common errors

There are certain systematic mistakes that people make when they make decisions about money. You can protect yourself by identifying them and staying away from emotional triggers.

The following advice can be taken into account with investments:

  • Don't make an investment decision on the same day a significant event takes place in your life, which could cause you to become emotional.
  • Take the information out of the context in which it is presented, as the presentation can create illusions. A salesperson will seldom tell you what the product is not. They put the product in a narrow frame by telling you only about its benefits. However, your decision could change if the frame changes and you gain more information.
  • Realise the power of marketing. When your financial adviser advises you, make sure he or she knows what your frame of reference is. This determines how you approach problems and investment products. If the financial adviser understands your needs, this reduces the chance of a misunderstanding occurring or of your money being placed in an unsuitable investment. An example of marketing power would be if a reader assumes that because a company has won two Raging Bull awards, its funds would be good investments. This is not always the case.
  • People become very emotional about losing and this is known as risk aversion. They can hold on to a losing investment simply to try to break even. By holding on to the losing investment, they avoid regret but they also do not assume responsibility for their mistake.
  • Be aware of your mental accounting habits. People treat hard-earned money conservatively while they tend to treat "easy" money or windfalls more recklessly.
  • A common cognitive error is that of anchoring, where investors become fixed on ideas. Often an investment product is sold with a projection value that is based on factors at the time of sale (such as inflation). The projected value is based on the assumption that you will not disinvest ahead of schedule. Investors can become fixed on this projected value and when the investment eventually pays out, this can lead to disappointment if factors, such as interest rates, have changed significantly.

An example of this would be a person who bought a property for R400,000 and then an estate agent valued the property at R1.5 million at a later stage. Several months after the valuation, the person receives an offer to purchase for R1.2 million. The typical reaction would be a reluctance to accept the offer despite the fact that the profit would be considerable. In this case, the seller is fixated on the figure of R1.5 million.

Conclusion

You would be better off if you did not anchor on historic prices, perceptions or historic values.

Please contact us if you would like more information about this aspect of investments, or if you would like to review your existing investments.