Welcome to Part 8 of our Behavioural Finance series. If you’ve missed the earlier parts of the series, you’ll find our Introduction to Behavioural Finance here, Part 2: Prospect theory and loss aversion here, Part 3: Availability and Representativeness here and Part 4: The Law of Small Numbers here and Part 5: Anchoring, Conservatism and Herding here and Part 6: Overconfidence and Under-Confidence here. and Part 7: Self-Serving Bias here.
We’ve considered a range of biases already in our series on behavioural finance. This week we will look at ‘projection bias’ and how it can impact our investment decision-making. We’ll also be seeing how ‘magical beliefs’ can bewitch the superstitious investor.
Although we may not recognise it by name, we’re all familiar with how projection bias can affect us in everyday life. It’s when we make the mistake of thinking that our preferences in the future will be identical to the ones we have in the present. An example of this is when we find ourselves hungry while we’re in the supermarket, which can often lead to a trolley full of food we don’t need, and a bigger bill to boot. The mistake we make is thinking that in future we’ll be as hungry for all this food as we are when we’re in the supermarket.
Projection bias is the tendency to assume that our needs, tastes and preferences will stay the same over time. In financial planning terms, this could lead to problems in gauging future expenditure correctly, and incorrect assumptions about the money we might need to set aside for retirement. It’s common to think that we won’t need as much money in retirement as we do when we’re working, but with more time on our hands, our expenditure can increase in ways we hadn’t expected, particularly on leisure and holidays.
There’s also the problem of the ‘ostrich mentality’ when people refrain from projecting altogether, and just bury their head in the sand hoping that everything will work out somehow. At First Wealth, we conduct a ‘Where Are You Today?’ questionnaire with clients, along with cashflow modelling, to work out how to get them from the present day to the ideal retirement they want. This helps investors to understand how their financial future is directly shaped by the daily decisions they make in the present.
Inadequate insurance cover can be another example of projection bias in action. Many people waive critical illness cover under the assumption that they will remain generally healthy. The correct level of insurance is as important to your financial planning as the make-up of your portfolio. As advisers, we regularly ask clients big questions about life, death and health, which can be uncomfortable for clients who have never engaged with these topics before. However, our job is to make sure clients have planned for all eventualities, including the curveballs that life can throw at us, which can affect your finances but have nothing to do with investing – like incapacity, illness or death. It can be easy for an adviser just to go along with the client when they reject insurance, but it’s our responsibility to make clients understand how vital it is, and that they are not immortal or immune to illness. For all new clients, we recommend income protection, critical illness and life cover to make sure they and their families are protected for these eventualities.
Professor Kahr gives his insight on why we find it difficult to address questions of our health and mortality head on:
“Each of us begins our life in a helpless, infantile state in which we have no option but to depend upon the care-giving of others. Thus, we project all responsibility outwards. In view of our vulnerability, growing up becomes a challenge as we must, step by step, learn to become less dependent upon our parents. It should not surprise us that, during times of stress, we regress to more infantile states of dependency and we wallow in a state of helplessness and denial. This applies not only to our intimate relationships but also to our business affairs, as we run the risk of denying adult realities and of projecting responsibility onto others.”
Magical beliefs don’t sound like a concept you’d expect to come across in a discussion of economic theory – perhaps seeming more suited to the pages of J.R.R. Tolkien. However, they’re the name behavioural economists give to certain preoccupations we have as humans that have a real effect on our decision-making, but that are difficult to fit into more scientific categories. We usually refer to them as superstitions.
After two days of sunshine and warmth at the beginning of a British summer, rushing out to buy sunblock and deck chairs, then booking the week off work would be considered to be ‘tempting fate’. This belief that our actions can somehow result in a change for the worst, even though the circumstances are completely beyond our control, can also affect our financial decision-making.
For some people, rising share prices can make them wary about investing their money in the stock market, lest the markets start to fall as soon as they buy. These people end up sitting on their hands and watching the market go up, trying to pick the perfect time to invest. As any good advisers will say, it’s ‘time in the market’ rather than ‘timing the market’ that will bring results. Drawing up and sticking to a long-term plan is a far more reliable route to your financial goals than short-term gaming of the market. As an adviser with an eye on the markets at all times, I too can be tempted to cash in on some of my own long-term investments if they have done well, but I have to remind myself of the commitment I’ve made over the long-term. I try to coach myself in the same way I coach my clients.
Speaking of magical beliefs, when choosing a financial advisory practice, some investors can find themselves bewitched by the mystique and prestige of some of the more traditional firms. Long-established firms tend to be long-established for a reason, and they can point to past and present success that underpins their reputation. However, what’s important for investors is that they choose the advisory practice that’s right for them, not the one with the highest profile or the longest history.
First Wealth is a young, modern, forward-thinking practice, which might suit some investors better than a bigger, traditional firm. Our business is our baby and we work hard to provide a bespoke, individual service that completely satisfies our clients and reflects our people-first approach. If you would like some help in planning your ideal financial lifestyle, please feel free to get in touch.
Questions to Ask Yourself
How strongly do you agree or disagree with the following statements?
- I often expect investments to decrease in value shortly after I buy them.
- I won’t need to think about passing on my estate until I’m closer to retirement.
- I’m confident my financial situation in retirement will be better than average.
Next post: Mental Accounting. Read it here.
This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.