To err is human to plan is a good idea
Sound planning can help you avoid emotionally charged investment decisions and keep you on track to achieve long-term financial goals.
Economists like to think of people as rational beings who make rational financial decisions based on what is best for them now and in the future. But people are, well, human.
We’re emotional beings and emotions tend to colour our decision making. Negative feelings like anxiety, fear and panic – things we’ve become all too familiar with in recent months – can hinder our ability to think ahead and forecast our future needs.
Victoria Baranov, senior lecturer in economics at The University of Melbourne, says the current global coronavirus pandemic has caused a great deal of stress and fear and these feelings can lead to poor financial decisions.
“Typically economics has focused on rational decision-making, but we now understand decision-making is affected by the emotional state people are in,” Baranov says. “If they feel stressed, are in fear, are worried about budget constraints or feel there is scarcity, they end up putting pressure on their mental bandwidth.
“When people are in a very emotionally charged state, they are more prone to decision-making errors, especially for longer-term consequences.”
We all take shortcuts
Famed psychologist and Nobel Prize winner Prof Daniel Kahneman discovered the human mind takes short cuts based on “cognitive biases” which are essentially beliefs based on misinformation or misconception.
These mental short cuts can be a good thing; they allow us to make decisions quickly which is particularly helpful if you’re facing a dangerous or threatening situation. But they’re generally unhelpful when it comes to financial decision making.
Johann Maree, head of practice management for Mercer Financial Advice, says the first and most important step to managing cognitive biases is to recognise they exist.
“Understanding biases and why we behave the way we do helps us manage our emotional reaction to market noise, so that we can be confident in achieving our long-term goals,” Maree says. “The Global Financial Crisis was a good example; staying on track during those extreme circumstances was very stressful, but clients who played the long game were much more likely to recover well.”
Maree says investors should consider:
- Forming a financial plan with clear expectations, goals and systematic processes
- Working with an adviser to help manage emotional reactions to periods of market volatility
- Always taking a long-term view