We spoke to Simon Russell, Founder and Director of Behavioural Finance Australia, about some of the ways that our unconscious mind might be calling the shots when it comes to investing.

What happens to our brains when we make decisions?

The idea that we’re making decisions in a subconscious way might be hard to accept, but the fact that it doesn’t feel like it’s happening is actually a bias in itself — it’s called a blind spot bias. Maybe we can understand that other people operate this way, but acknowledging that we’re just as susceptible is a hard barrier to get past.

Bias 1 – Loss aversion

By no means an uncommon instinct, loss aversion is when we feel the pain of a loss more than we feel the pleasure of an equivalent sized gain. Imagine it’s a windy day, you open up your wallet and a $50 note flies out and goes down a drain. For many people, the pain of losing $50 would be greater than the pleasure of finding $50.

While the extent of loss aversion will vary between people and across contexts, we can illustrate how we might feel by saying one gives us 50 units of pleasure while the other gives us 100 units of pain.

Some people will be much more loss averse than others. Say you presented a younger adult with an opportunity where there was a risk of losing $10,000. If that amount represents their entire life savings, then they’ll probably be terrified at the prospect. But you might get a different response from a wealtheir person whose investments go up or down by $10,000 every few days.

How can someone overcome the fear of losing money?

There are some strategies that don’t even require much of you. For example, when it comes to superannuation the less you look at it, the less sensitive you are to it. If you’re obsessively checking your super balance, it’ll feel like there’s a 50/50 chance that it will be up or down on any given day.

But if we look at things over a longer period, it tends to become more weighted in favour of gains. So, if you’re the type of person who feels losses more heavily than gains, checking your balance less frequently may help with this.

Bias 2 – The recency effect

The recency effect is the idea that we focus more heavily and clearly on things that have happened recently. This is often quite useful in predicting things — if Usain Bolt was a fast runner yesterday, chances are he’ll be a fast runner tomorrow. The problem is when there are certain events that might be important or instructive, but because they’re beyond our ability to recall them, they cease to influence our expectations.

In the case of investing, looking at what’s happened recently can actually throw us off. There’s so much randomness and uncertainty swirling around in the moment, and we might be better served by making decisions with an eye towards the longer historical period instead. Yes, one particular asset class might have outperformed another last year, but let’s take a ten-year view (or longer) and see what we can glean from that.

Bias 3 – The familiarity effect

The familiarity effect is when we develop a preference for something merely because we’re familiar with it. There are strong investment parallels here. When choosing an asset class to invest in, are you basing it on a thorough assessment of all available options and their suitability given your risk tolerance, investment goals and time horizon? Or are you just going with what you’re familiar with?

Take the bias many people have against global equities compared to domestic ones (which is often referred to as home country bias). This might be countered by looking up international funds and checking their holdings for companies you recognise. Chances are there will be several names that are familiar to you. You might also be able to create familiarity by way of analogies. If someone is uncertain about how dividends work, having them likened to rent received from an investment property might help things click into place.

Written and accurate as at: Jul 12, 2024

This information provided in this article is general advice only and has been prepared without taking into account your own objectives, financial situation or needs. Before making a financial decision based on this advice, you must consider whether it is appropriate in light of your own needs, objectives, and financial circumstances, and where relevant, obtain personal financial, taxation or legal advice. Where a financial product has been mentioned, you should obtain and read a copy of the Product Disclosure Statement (PDS) prior to making any decisions about whether to acquire a product.