Warren Buffett once said, “If you don’t find a way to make money while you sleep, you will work until you die”. While this statement sounds a little blunt, he has a point.
To me, building wealth and passive income isn’t about increasing the money in your bank account. It’s about giving you options and the freedom to make the choices that you want in life. The most valuable thing to most people in the world is not money; it’s time. Time with family and friends. Time to travel and explore the world. Time to enjoy being at home or in nature, relaxing and feeling comfortable. Time to be generous towards people important to us or those less fortunate.
We all have things that we want to achieve in our lives which take time, money, expertise, or sacrifices to achieve. The trouble is, when we are pursuing our goals, we often get in our own way without even realising it. We prioritise things that aren’t that important to us and convince ourselves of things that aren’t true if they help us to justify a decision that we think we want to make.
This happens because there are several mental biases and behavioural traps that plague us as consumers & also as investors. This field of study is known as Behavioural Finance.
When we understand our behaviour and identify these biases, we have a better chance of being able to self-regulate our actions. Many books have been written on this topic as it is varied and diverse in its findings, but here are 8 of the most critical behavioural biases to be aware of:
A tendency to do nothing or to remain unchanged is one of the biggest traps we can fall into when creating wealth. Delaying your commencement, delays when the power of compounding can start to take effect and means that we must do much more heavy lifting in the future to make up for this inaction.
We delay things because we prioritise today’s enjoyment over our future enjoyment. One of the reasons Australia has compulsory superannuation contributions is to overcome this mental bias. Governments and industry members know that If we leave it up to people to voluntarily save for their retirement, few will do so.
2. Herd instinct:
Doing what everybody else is doing is often caused by “FOMO” (Fear of missing out) or “FONGO” (Fear of not getting out).
When the market is strong, people tend to feel more confident about their investment choices as taking risk feels great when it’s paying off. When the market has crashed, and people have potentially lost money on their investments, they feel less optimistic and less willing to take a risk because now the risks seem real and scary.
Unfortunately, our gut instincts are leading us astray and encouraging us to buy and sell at the worst possible times.
Trading too much because of a belief that you can outsmart everybody else and time the market better than they can.
Many investors earn lower returns not because of the investments they choose but because of the way they use those investments. According to Morningstar’s 2014 study, the average investor returned 3.01% less a year than the average return on International equity funds because of the way they traded over time.
4. Ignoring lessons from the past:
As mentioned above, when the market is going up, risk feels great. Our overconfidence linked with our herd mentality leads us to think “this time is different!”
As at the date of writing this, the S&P 500 in the US is at all-time highs and currently in the longest Bull market in more than 120 years.
Passive investments and Exchange Traded Funds (ETFs) make a lot of sense in a Bull Market as they are cheap to access and trending upwards. But just as they will go up in a good market, they will follow the trend and go down in a bad market.
Active fund managers cost more to access, as you are paying for their expertise and skill, but the good ones are worth these fees if they outperform in a falling market.
5. Loss aversion:
Most people can relate to the fact that negative emotions, such as when we receive criticism, has a stronger impact on our minds than good emotions, such as receiving compliments.
Whether a transaction is framed in our minds as a loss or as a gain is very important to our feelings about that investment. Some psychological studies have suggested that losses are twice as powerful as gains to experience.
These feelings can lead to us selling winners too soon (to lock them in) and losers too late (so we can put off making the loss real).
6. Home bias:
This refers to investing only in what we know or are familiar with. Australia makes up less than 2% of the world’s financial output. Yet, many investors hold the majority of their portfolios in Australian owned assets.
Compared to other markets, Australia has a reasonably small exposure to Technology and Health Care companies, and we are massively overweight to the Financials and Resources sectors. Without accessing investments from overseas, it is difficult to overcome this imbalance.
7. Lack of diversification:
Portfolios that are too concentrated have much higher levels of volatility (a wider range of possible negative or positive returns). Diversification is one of the best ways we have to manage risk and reduce volatility.
Many people think that timing the market and picking the best assets is the most significant factor in a portfolio return. But multiple studies over the last 35 years have shown that up to 90% of your return comes from your asset allocation (i.e. how much you allocate towards domestic & overseas equities, property, cash, bonds etc.).
The term “di-worse-ification” refers to diversifying without benefit.
One of the lessons we learnt from the Global Financial Crisis (GFC) in 2008 to 2009 was that when we need it most, diversification fails us. What we saw during this time was almost all Growth asset classes (equities, properties, commodities, etc.) following the same trend and falling in value at the same time.
Diversifying is not about collecting a random assortment of different assets; it is about managing your risk by bringing assets together that are uncorrelated to each other at the right time.
Now that we understand a bit more about our minds, here are some tips to help us manage our behaviour:
1. Pre-commit to productive things.
Pre-commitment is a great way to overcome inertia. Set up direct debits to your savings plan, mortgage, super fund, investment portfolio etc. If you feel like you cannot afford to do this, review your spending and consider where you can make some changes. Small changes over a long time can have a considerable effect. So, start small and commit to reviewing and increasing this over time.
2. View your income on a weekly basis.
Set the account(s) that your bank card links to, to receive a weekly transfer to cover your living and recreational expenses. Saving or investing needs to come as a priority, and this small change is a framing exercise as it changes the way we view our cash flow and impacts on our spending behaviour over time. It also means that as earnings go up over time, we don’t just consistently increase our spending without realising or benefiting from it.
3. If you are self-employed, keep up with your super contributions.
This is one of the biggest traps we see self-employed people get into. When you are growing your business or your family, saving for retirement doesn’t feel as important and often gets put on the back burner.
You not only lose out on annual tax deductions, but you also lose years’ worth of investment returns compounding on each other to help you live comfortably in the future. Relying solely on an eventual business sale doesn’t always work out, and this can leave you in a vulnerable position.
Make your contributions monthly rather than leaving it to June each year and giving yourself the opportunity to opt-out.
4. Stay away from credit cards/Afterpay etc.
Studies have proven that credit cards make you spend around 12-18% more than you otherwise would. This is why credit card companies give you “free” stuff.
This additional spending doesn’t make you any happier in your life, but it does significantly impact on your future financial wellbeing.
5. Don’t make financial decisions in a highly emotional state.
When we are emotional, our decisions are often driven by fear or greed. Fear and greed encourage us to think illogically and ignore information that feels uncomfortable, or that doesn’t support our existing views.
As Warren Buffet once said, “Be fearful when others are greedy, and greedy when others are fearful.” Professionals can help here as they are further away from the problem and better able to think objectively.
6. Rather than prioritising the present, be mindful and present when spending.
It is easy to tap away without thinking, as most of us don’t want to stop and think about every transaction. But if we don’t think at all, then it adds up over time.
Think about what you are spending your money on and equate this to your hard work. i.e. this object/dinner/car/holiday is equal to X hours of work/time away from my family. Am I getting enough value for that amount of effort/sacrifice?
7. Have conviction for your buys.
It is vitally important to have a strategy and a reason why you are buying an investment. FYI because your cousins, girlfriends, boss’s sister said it was a winner, is not a proper strategy.
If you have conviction about each investment you make, then it is less about trying to time the market and more about having time in the market. If you know why you bought something, then you also have a better understanding of when it comes time to sell it.
8. Remember that great companies can be bad investments.
Although we cannot always time the market, paying a fair price for something is still important. We need to separate in our minds what makes a good business versus what makes a good investment opportunity. Sometimes they do not go hand in hand as a great company or product may be significantly overpriced.
You should consider the fundamentals of a business or property and the future for its industry or area before deciding to make a purchase.
9. Make hold/sell decisions by reflecting on the future, rather than the past.
Sometimes an investment decision doesn’t play out the way we think it will. Not selling something because it is currently worth less then what we paid for it results in us holding on to bad investments for too long.
It is important to reflect on whether you would purchase the asset today if you had the cash and what prospects it has in the future, regardless of what has happened historically.
10. Consider tax implications; don’t let them drive investment decisions.
Holding onto an asset purely because you are going to pay tax on the gain if you sell it is short-sighted. This strategy might make sense if your tax threshold is going to reduce in the near future, but if not, the best alternative you are telling yourself is that the asset drops in value so you can pay less to the ATO. In reality, you will also have less left over after paying the ATO.
It is essential to consider and plan for any tax implications, but if it is time to sell an asset, it is time to sell it.
This philosophy also applies to negative gearing just to get a tax deduction. Unless you buy a quality asset that goes up in value over time, you are still paying to hold that asset each year and impacting your cash flow.
11. Don’t use diversification for diversification’s sake.
Diversification is no doubt important, but it needs to be well thought out and done with purpose and consideration for how each piece of the portfolio works together.
Fixed interest (Bonds or Credit) is considered a Defensive asset class, but it is often misunderstood and misused in a portfolio. Not all credit is created equal, and it is crucial to understand what you are investing in and how it might behave during adverse market conditions.
Our behaviour and environment impact on our ability to safely navigate the complex world of finances and investing. By understanding our behaviour and adjusting our environment, we all have the power to improve our financial wellbeing. But we need to be willing to put in the effort. If you are unsure where to start, a financial adviser can help you plan, make decisions, optimise your position or get things done.
Disclaimer: The information in this article is general in nature and should not be taken as constituting advice from TWD Australia or its associates. You should consider seeking independent legal, financial, taxation or other advice to check how this information relates to your unique circumstances.