How we make financial choices and why we hate losing
Why do we hate losing money more than we like making it? Why will we keep an investment that is making a constant loss hoping it will go back up some day when we know we really should exit and put the money to better use somewhere else?
Behavioral Economics gives insight into why we don’t always act rationally when making these tough financial decisions and to explain it in simple terms we have Kara Child on board! Kara is a Senior Wealth Manager at Pitcher Partners and has studied Behavioral Economics and the psychology of investing.
How is it theoretically assumed that we make financial decisions?
Standard economic theory states that people make rational choices based on 3 assumptions. Firstly that we have rational preferences (we either prefer one thing over another or we are indifferent between the two). Secondly, it is assumed people will always aim to maximise their utility (the satisfaction you get from a choice). Finally, that we have access to all the required relevant information (which isn’t true even with google, we are presented with wrong information or struggle to find what is relevant). If these 3 points were true, any decision we make would be logical and rational. From this came Behavioral Economics, which investigates why people aren’t acting in this rational way and what might be impacting our decision making.
Why do we not always make rational decisions?
Simply put, because we are human! We have emotions and we are influenced by things around us. This leads to a range of bias, we simply don’t always see things as black and white in a logical manner.
So what influences our decision making?
A big one is loss aversion. People don’t like to lose… we prefer to avoid a loss rather than reap a profit. So what we see in the share market, is people holding on to losses regardless of advice to exit the market. Acting rational in this circumstance would be to to sell at a loss and reinvest the money into a different asset that has growth potential.
Emotional attachment is another big one. Whether it’s a beautiful home that we don’t want to let go of, or a company that we really believed in which just isn’t performing like we hoped. Emotions come into play and instead of looking at the numbers, we act irrationally. The past can also affect our decisions, for example the GFC. People are still anchoring on that one point of time regardless of great returns in the market since then.
Knowing this, what should we think about when investing?
Of course keep in mind that this is all part of being human and without our emotions we would be not too different from robots...but being aware that bias is sneaking in without us realising can help us step back and make a more rational decision.
We generally have two systems of thinking, the first one makes our quick, default decisions. The second takes time to process and thinks more analytically. Unfortunately we often only use our system one thinking which is where our bias sits. If an investment hasn’t experienced growth in value for a long time, have a think about why you are still holding it and whether you need to reevaluate or seek advice.
Being aware of this decision making is helpful not just for when you are in a loss but for when you are in a gain too. At what point are you going to take the profit and go? Set yourself a price ceiling so you don’t hold on too long and miss out on great profits (hello Bitcoin investors…). We might not want to be the person who ‘got out too soon’ but holding on too long can sometimes be no better.
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Caitlin and Rachel Treasure