Humans are dealing daily with the struggle of balancing logic and sentiment.
Every individual needs to find the perfect compromise to satisfy heart and mind. As a result, many of the decisions made by humans are dictated by the heart and not the brain and unfortunately when it comes to finance, sentimental decisions can sometimes be costly.
One of the balancing decisions many individuals come up with, is whether and how to invest? Afterall, investment is the replacement of current consumption for a potential increase in spending power in the future. For example, someone needs to decide whether to buy that nice pair of shoes they saw online or invest the money in aide of their retirement. More often than not, we have all been in that person’s “shoes” contemplating the financial sense of a purchase.
From a traditional finance standpoint, for the so called Rational Economic Man (REM), investing the money rather than purchasing the shoes is a no brainer. REM’s single mission is to maximize wealth.
Where traditional finance fails, is to incorporate the fact that humans are not emotionless self-interested robots. For example, people devote time and money to charity, are concerned with environmental, social, and economic issues and are willing to accept less gains rather than compromising their ethical and moral beliefs.
In response to the shortcomings of traditional finance many studies and theories have emerged building up to the so-called behavioural finance. Some notable concepts/conclusions of those theories are:
- Losses weigh more than gains: The emotional impact of a loss to an individual is greater than an equal gain
- Satisfactory is good enough: When it comes to financial decisions people tend to go with a satisfactory decision rather than grinding for the optimal solution. This most of the time is attributable to the time/cost trade off
- Framing: Many financial decisions might differ based on the way the information is presented. For example, let’s assume that a hypothetical investment has 80% probability to return 8% and 20% probability to return -2% in the first year. The following statements describe this situation:
- This investment has an 80% probability to return 8%. On average it is expected to return 6% in the first year
- This investment has an 20% probability to return -2%. On average it is expected to return 6% in the first year
Do the above statements have the same appeal, or would the first statement intrigue you to invest while the second statement refrain you from investing?
If finding the right investment sounds daunting and overwhelming it is perfectly natural and might well be attributed to behavioural biases.
In the heart of behavioural finance for individuals are the behavioural biases that distinguish individual investors from the rational decision makers of traditional finance. Have you ever come across someone that attributes all correct decisions to himself and all bad decisions to other factors? This is an example of a behavioural bias namely the self-attribution bias.
The study of behavioural biases of individuals is helping advisors to better understand and respond to client reactions and needs. At Hellenic Bank we are aware of how these biases can become obstacles in reaching your financial targets. Whether your goal is to build a nest egg for your retirement or you want to invest for a better world, in collaboration with our strategic partners, Allianz Global Investors, we can help you navigate not only through the complexities of the investment world, but also through your own biases in which you frame your decisions.
Advisor, Wealth & Investment Services, Hellenic Bank