Everyone makes dumb financial decisions at some point. It can even be the lack of action that is a dumb financial decision.
These not-so-smart decisions are something I’ve been ruminating on since a very academically gifted person told me during the last dip that he wouldn’t invest in funds because “the ones I looked at have been reporting negative returns since last year.”
What’s wrong with this statement is that investors make more money if they buy when funds are down. How could this otherwise smart person not get that buying low is an advantage? What’s behind that all-too-common thought is a cocktail of psychological biases, most of which I’ve written about before. But the combination is interesting.
Here are some of the key factors at play:
- Loss Aversion: people tend to feel the pain of losses more intensely than the pleasure of gains. So, even though markets going down might mean it’s a good time to buy thanks to lower prices, people fear further losses and avoid investing.
- Recency Bias: people often give more weight to recent events and assume that current trends will continue. If the markets are down, they may irrationally believe that they’ll keep going down, even if history shows markets typically recover over time.
- Emotive decision-making: investing decisions should be based on logic, data, and long-term strategies, but feelings and emotions can cloud judgment. Fear, uncertainty, and anxiety about market volatility can cause people to avoid investments, even when it’s objectively a good opportunity.
- Short-term focus: Being concerned about returns on investments for very short periods leads some people to sell when they should hold. If they see negative returns over the past year, they might think it’s a bad investment, even though the long-term outlook could be positive. This short-sightedness can prevent them from taking advantage of a market dip.
- Confirmation Bias: people tend to seek out information that confirms their existing beliefs. If someone is already fearful or sceptical, they might focus on reports of negative returns to reinforce their hesitation, rather than looking at broader historical data that shows the benefits of long-term investing.
- Overestimating risk: when markets are down, people often overestimate the risk of investing, focusing too much on the possibility of further declines rather than recognising that downturns are a normal part of the market cycle. Like my friend, they might miss out on the fact that downturns often present good buying opportunities.
- Herd Mentality: people often follow the crowd. If others are pulling back from the market, they might feel pressure to do the same.
The human brain is not well evolved to handle money, which is one of the reasons that people make these mistakes over and over. Financial management is remarkably complex for us.
Financial adviser Tim Fairbrother of RIVAL Wealth sees smart people making other dumb mistakes with their money as well as the buying-high-and-selling-low mistake above.
A big one is lifestyle creep, says Fairbrother. That’s where people’s spending grows to match their income, meaning they can’t get ahead no matter how much they earn.
“Getting high-interest debt on fast-depreciating assets. Things such as cars or furniture or boats. You should always have savings if you want to spend money on toys rather than borrowing.” Fairbrother says 15% or more interest on these toys adds up.
Not having enough personal insurance is also a trap for otherwise smart people. “People often believe that they’re wealthy because they’ve got an expensive house and a high income, but generally that’s backed by a very high level of debt. Only 50% of Kiwis have life cover, and far fewer have income protection insurance, which is insuring the machine that makes the money. They insure their house but don’t insure themselves.”
Failing to make active decisions around KiwiSaver and other investments. Earning 1% less per year than they could, multiplied by 30 years, is very expensive, Fairbrother said.
Mortgage adviser Jeff Royle of iLender has a good point about how smart people fall into making these mistakes. In the age of social media, too many people take their advice from podcasts and influencers, which is a variation of listening to the guy down at the pub, said Royle. This is exactly what my smart friend had done. He felt he could get all the advice he needed on the internet, without paying a financial adviser.
