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By Paul Gregory, Director External Communications and Investor Capability, Financial Markets Authority
Our feelings and fears can lead us to make bad financial decisions. A new government report reveals where we’re going wrong.
We’ve all done it – walked miles to save a few dollars on a purchase one day, then spent over the odds to get the hottest new product the next. We know this kind of decision-making is imperfect, and the logic is flawed, but emotion rules the day.
These tendencies are common in everyday life. But they can lead to much poorer outcomes when we need to make financial decisions, especially when it comes to more complex choices – such as how much to save for retirement, or which products to choose to help us get there.
The impact of a poor financial decision can last a long time – and get progressively worse.
Emotion in decision-making
Psychologists around the world are working on understanding the feelings and fears that drive people’s decisions and often lead to poor outcomes.
In New Zealand, the Financial Markets Authority has produced a report that looked at the mistakes we make and asked what could be done to help people make better investment decisions.
We tend not to make big financial decisions very often. So it can be hard for us to assess the risks and complexities of different financial products. Emotions come into play as we consider the trade-off between spending now and investing or saving for the future.
Whether you’re aware of them or not, it’s your preferences, beliefs, and the way you’ve learned to make decisions that influence your financial choices.
This is the battle between emotion and logic.
Preferences sway our thinking
Our emotions and past experiences affect what are known as our ‘preferences’. When it comes to money, we tend to value what’s happening now over what might happen later – a ‘present’ bias. For example, you may overspend on your credit card and pay off less than you should.
When we try to assess the value of something, because we’re not statisticians we confuse proportions, differences, and absolute values. For example, we find it hard to sell our home below the price we paid for it, even if the price is now above market value. We are ‘reference-dependent’.
Emotional responses are a powerful force in decision-making. We buy insurance to avoid potential regret, even if it is expensive – we pay ‘regret premium’. We are often happy to spend that money, but then we won’t sort out an actual, existing debt problem. We want to avoid stress and sometimes we don’t want to have to decide.
We are also hard-wired to fear losses. It’s easier to make choices based on the risks we know, rather than those we don’t. Many of us would think about switching to a less risky KiwiSaver fund if there was a big dip in the market, even though that would lock in the loss. We struggle with ambiguity and our ‘loss aversion’.
Our beliefs about the likelihood of events and our own abilities are often wrong.
We tend to be ‘overconfident’ in our own abilities and unrealistically optimistic. We might ignore overdraft charges when we choose a current account because we’re convinced we’ll never be in overdraft.
We’re very prone to making predictions based on insufficient observations. For example, we might assess financial advice – or worse, testimonials – as being good on the basis of a few successful investments, even though these could be down to pure luck. We ‘overextrapolate’.
Along with our preference to focus on the now, we naturally expect our current feelings and attitudes to remain unchanged. This makes it hard for us to guess how much our preferences and circumstances will evolve as we grow older. As a result, we can’t estimate accurately how much we need to save. This is known as ‘projection bias’.
We have a tendency to use shortcuts when we’re assessing information.
Many of us allocate money to different ‘mental budgets’. This can lead to poor decision-making if we can’t see past our mental labels. For example, if our day-to-day money runs out, but there is still money in the ‘holiday’ account, we may find it difficult to use the holiday money instead.
Mental accounting and biases also cause us to make decisions in isolation, rather than thinking about other related decisions. For example, we may choose an individual investment product based on just one factor, such as its risk indicator, rather than considering it as part of a holistic investment portfolio.
Making good investment decisions
Rest assured that the financial services industry understands the part emotional factors play in people’s decisions, and it uses these emotions to sell to you.
The Financial Markets Authority is calling on the industry to use the insights more broadly, to help New Zealanders make better investment decisions. So, how can this be achieved? It can be done by making it easy, attractive, and timely for you to make financial decisions. It’s also about making decisions ‘social’, which requires a public commitment, such as telling your friends, as the first step.
It’s in all our interests to have New Zealanders making good investment decisions. We can’t have fair, efficient, and transparent New Zealand financial markets – which are bigger, deeper, and more sustainable markets – if decisions are being made on the basis of bias or other emotions.
To find out more, read the full report ‘Using behavioural insights to improve financial capability’ at www.fma.govt.nz.