Money behaving badly
First published on 05 of June 2015 • Updated 23 of January 2017
You might think your finances are all about the numbers, but it’s easy to forget one of the biggest factors: people. Money is spent by people, and human beings behave far less predictably than numbers. Graham Clark of NW Brown introduces the mysterious world of behavioural finance.
When you’re putting together any sort of investment plan, there are many different variables to consider – such as present income, current and future needs, growth rates and so on. But one of the most important variables is also one of the most complex: it’s you. Your own personality plays a critical role in how you relate to your money, and is one of the biggest drivers behind the financial choices you make. This can have major implications on how your money performs over time – because different personalities may interpret the same information in very different ways.
Take the contrasting cases of Sally and Craig. They have each made an identical investment. Over one year, the market average rises 10 per cent, but the individual investment value increases by just 6 per cent.
Sally cares only about her investment return, so she frames this as a gain of 6 per cent. Craig, on the other hand, is concerned about how well the investment performs relative to the benchmark of the market average. From his point of view, the investment has lagged behind the market’s performance, so Craig perceives he has made a loss of 4 per cent.
Because individuals tend to feel losses more than gains, Sally is much more likely to be happy with her investment than Craig is, even though they have had the same level of return. Their differing reactions here will frame their future investment decisions.
Another key issue when investing is the prevalent tendency for individuals to frame their investments too narrowly. For instance, an investor may look at the performance of her fund over short time periods, regardless of the fact that she has set a long-term investment horizon. Such a person will perceive their investment in a poor light and may be tempted to change it – when it may well be delivering everything required. An investor may also struggle to consider his portfolio as a whole, and will instead focus too narrowly on the performance of individual components.
Much about investing may seem counter-intuitive, depending on the individual. People who are not naturally long-term planners may feel very uncomfortable with short-term losses, and react impulsively. Conversely, the habitual long-term thinker runs a risk of neglecting their investments and missing opportunities as they arise. At some point, many investors may need to act against their grain of their personalities.
The 70 per cent rule
Here’s another example. Consider the familiar ‘70 per cent rule’ for retirement – it’s a simple rule of thumb that advises people to plan on spending about 70 per cent of their current income during their retirement.
For most people, this suggestion is intuitively appealing, which could explain why it has become so popular among financial planners. However… what if we were to rebrand the 70 per cent rule as the 30 per cent rule? What if we said, ‘You need to spend 30 per cent less in retirement than you do at the moment’? Probably a majority of people would struggle to think of the 30 per cent of expenditure they could cut, and would find any such recommendation unpalatable. Yet the 70 per cent and 30 per cent rules are mathematically identical. It’s all about how the information is presented, and how it is processed.
Myopic money management
It’s common for an average stock or fund to fluctuate a few percentage points in a very short period of time. Investors who are particularly sensitive to losses will tend to over-react to these fluctuations, and so take a short-sighted view of the market. This, ironically, may deter them from investing in the most suitable portfolio. If the purposes of an investment is to provide money in, say, five or ten years’ time, then only the long-term view counts – everything else is irrelevant. Some personalities instinctively grasp this, whereas for others it can be a lot harder. But a good financial planner should also understand human behaviour – and so can put your mind at rest if you don’t think your investments are behaving as they should.