Have you ever had the feeling that you made a bad investment? Or that you didn’t make the right decision for your money? Nothing could be more normal. It happens to beginners and seasoned investors alike. Behavioral finance research has shown that investor psychology is a major source of misjudgment. This is due to cognitive biases, systematic errors in the way we reason and decide. These biases influence all the decisions we make in our daily lives, but some of them are particularly formidable for our financial behavior.
Loss aversion: why risk avoidance means losing every time
For many savers, it is natural to avoid taking risks because our brains associate the notion of risk with loss. And nobody wants to lose money! This reasoning intuitively keeps us away from so-called “risky” investments. We avoid investing in the stock market, which carries a risk of capital loss, in favor of investments with guaranteed capital: euro funds in life insurance policies, regulated savings accounts, or even our current account. All these investments are not investments at all, since they yield nothing (in the case of the current account) or at best 1.1% (average rate of the euro funds in 2020), i.e. less than inflation (2.2% annualized in September 2021). In other words: keeping our money safe from a potential risk of loss… It is actually losing purchasing power!
Our brain misleads us because it is much more sensitive to losses than to gains. Losing 100 euros affects us twice as much as gaining the equivalent amount. This is the direct consequence of our natural fear and protection mechanisms: our primitive ancestors were forced to always prepare for the worst case scenario in order to survive in a hostile environment. Today, faced with volatile markets that fluctuate up and down, we focus on the “risk” of losing rather than the prospect of winning.
However, historical statistics are clear: the risk of loss on financial markets diminishes over time. Investing in the MSCI World index (representing the world’s 1,600 largest companies) over one year means taking a 30% risk of loss. But this risk drops to 10% if you invest over 10 years and disappears completely for an investment of 15 years. Why is this? Because in the long term, the upward trend of the market is stronger than the fluctuations of their stock price. So be careful not to confuse volatility with loss. Investing is not only the best way to make money, it is also the only way to avoid losing money due to inflation year after year!
The present time bias: why one “yours” is worth less than two “thou shalt have”
Even though we know that we need to invest to prepare for the future, we have a hard time thinking about the long term. In many aspects of our lives, we value immediate satisfaction over the prospect of progress toward a distant goal.
The present time bias is the procrastination bias. The one that irresistibly guides us to that restaurant with friends rather than that Sunday workout we just can’t seem to stick to. At work, it encourages us to prioritize a multitude of small tasks, followed by a coffee with colleagues, rather than starting that large-scale work that will require hours of concentration. The same is true when it comes to our personal finances. Would you rather earn 1,000 euros today, or wait 6 months to earn, perhaps, 1,100? We generally prefer to secure an immediate gain rather than wait for a potentially higher, but more distant gain. In the same way, we have the bad habit of regularly checking the status of our investments and of making short-term decisions under the influence of emotion. For example: withdrawing our invested money when the markets fall, for fear of losing more, whereas waiting quietly for the recovery would be much more interesting if we don’t need it immediately. The financial markets need time to make our savings grow: we must give them time. Let’s take our MSCI World Index. Over a one-year horizon, we observe an average return of 6.8%. This prospect of gain explodes over the long term, as the risk of loss decreases: 40% over 5 years, 73.3% over 10 years and 169.9% for a 15-year investment! Why is this? Because investing over a long period allows you to benefit from capitalized interest: the capital gains and dividends acquired in the first year are reinvested the following year, generating interest in turn, and so on. We must therefore consider investment not as a prospect of immediate gains at a given time, but as a means of achieving our long-term objectives.
Information processing biases: why it is not enough to be informed to make a good decision
Do not confuse risk-taking with fear of loss, consider our finances in the long term… This is easier said than done. The reality is that our brains are simply not capable of handling the continuous flow of information we receive with discernment. Whether it’s information from our financial service providers (account statements), from the media (real-time market monitoring), from social networks or simply from our loved ones… None of this information can be processed objectively, without the interference of several totally unconscious cognitive biases.
To mention just a few, let’s start with the confirmation bias: we automatically select information that reinforces our choices. We are therefore more sensitive to the advertisements of the brand we consume than to those of the competing brand. And we are more receptive to arguments in favor of our financial decisions (“the Livret A is not taxed, so it doesn’t make you lose money”), than to those that contradict them (“an investment that yields a return is more interesting in the long term, even taking the tax system into account”). The anchoring bias, on the other hand, encourages us to remain fixed on our first impression, which prevents us from questioning our choices. The framing bias is particularly pernicious: we can make radically different decisions depending on how the same information is presented. To take the example of the MSCI World: if I tell you that investing in this index for 10 years carries a 10% risk of loss, you will certainly flee from this investment. And you will miss a great opportunity to get an average of 73.3% return, which you would surely have taken if I had presented it in this way. In summary, the volume of information we receive is too great. So we resort to shortcuts, simplified systems of thinking, which lead us to make decisions that are not optimal for our money.
The list of cognitive biases goes on and on and there is no point in going through it exhaustively. The point is that our judgment is inevitably biased, which can lead us to make poor financial choices.
What is the solution? Knowing your own biases is already a good start. Then you have to set clear decision rules and above all, stick to them. To do this, delegating the management of one’s performance is a precious help, because past performance does not predict future performance and only a professional will be able to help you keep a cool head in the face of market changes. We delegate decisions concerning our health: everyone knows the dangers of self-medication and it would never occur to us to dictate our prescription to our doctor!