Research on investment switching behaviour reveals the connection between cognitive biases and financial wellbeing.
Unfortunately, for some of us, when making a decision that affects our short, medium or long-term financial wellbeing, a behaviour gap can arise between what we should do (rationally) and what we actually do (irrationally).
This behaviour gap can often occur when we allow our decision-making process to be influenced by one or more cognitive biases—systematic errors in reasoning, evaluating, remembering, or other cognitive processes.
Again, a systemic error can arise due to one or more factual and emotional reasons—too much information, not enough meaning, the need to act quickly, and the limits of memory.
Importantly, these reasons can often be brought to the forefront due to an overarching factor—a low level of financial literacy and capability.
Unfortunately, the level of financial literacy of Australians isn’t equally shared. Results from a recent HILDA survey highlighted women, and those aged 65 and over, generally have a lower level of financial literacy.
When looking at cognitive biases, some of the most well-known are optimism bias, loss aversion, recency bias, confirmation bias, and herding. When these (and other cognitive biases) are allowed to influence our decision-making, they can impact our ability to accumulate and preserve wealth over the short, medium and long-term.
For example, loss aversion is the tendency for some of us to prefer avoiding the pain of losses more than the reward of gains. From an investing perspective, when a rational analysis (and long-term view) may suggest otherwise, a loss-averse investor may be influenced to make one or more of the following decisions:
- Sell a high-quality investment that has accrued gains, so as to realise those gains.
- Not sell a low-quality investment that has incurred losses, so as to not realise those losses.
- Sell a high-quality investment that has incurred losses, so as to stem any further potential losses.
- Invest in low risk/return investments, excluding potentially beneficial higher risk/return investments.
These examples, and others (eg investment option switching—think, as an example, changing risk profiles), can often occur during certain phases of an investment market cycle. Generally, an investment market cycle consists of four cyclical phases, and in the context of the share market, for example, are often illustrated as:
- recovery/bull run (rising share price)
- boom/peak (highest share price)
- downturn/bear run (falling share price)
- slump/trough (lowest share price)
Regardless of whether the above examples (eg selling a high-quality investment that has incurred losses) occur in conjunction or in isolation, they have the potential to affect an investor’s long-term investment performance—and, by extension, their long-term financial wellbeing.
On this point, a research study was conducted on the investment switching behaviours of super fund members during a financial crisis. The research study covered investment switches across three COVID-19 time periods:
- pre-pandemic phase of the COVID-19 financial crisis (1 January 2019 – 31 December 2019)
- early-pandemic phase of the COVID-19 financial crisis (1 January 2020 – 10 March 2020)
- during-pandemic phase of the COVID-19 financial crisis (11 March 2020 – 31 March 2021).
As highlighted by the paper published off the back of the research study findings*, the COVID-19 pandemic significantly impacted the Australian financial markets, for example:
- the market index (ASX200) had been steadily rising throughout 2019, hitting a peak of 7,139 on 21 February 2020. However, it then dropped 36% to 4,546 points over the following month to 23 March 2020
- a recovery then began, reaching the previous February 2020 peak almost 14 months later on 10 May 2021, with a closing value of 7,172. The market then continued to trend upwards to 7,534 at the end of August 2021, some 5.5% higher than the previous May 2021 peak.
With the above in mind, here are three high-level findings from the research study via way of analysis of over 42,000 single investment switch decisions made by super members from 1 January 2019 to 31 March 2021:
- Super member investment switching volumes, and ‘bad’ investment switches, grew dramatically. A near tripling of super member switching occurred in this crisis. Also, bad investment switches grew from 33.5% to around 50% during the crisis, many of which occurred in the during-pandemic period (downturn)—and, a large portion of which consisted of switching to cash, subsequently crystallising investment losses. A bad investment switch was defined as one having a worse impact on a super member’s balance over the period relative to not switching—having an average opportunity cost of -8.2% across the research study.
- Convenience, awareness, and coverage were significant factors in driving super member behaviours. It’s suggested that the increase in switching behaviour was directly linked to the ease of access to online switching now available to the average super member, combined with heightened consumer awareness of fluctuations in financial markets, fuelled by substantial media coverage through the pandemic (and crisis).
- Bad investment switches impact those who can least afford it. Unfortunately, many of those who can least afford it are most at risk of making bad investment switching decisions—women, who typically have lower balances to begin with, and older super members with less time to make good. For example, during the pandemic (and crisis), 52.4% of switch decisions made by female super members were bad (up 55.4% from 33.7% in 2019), and 69.2% of switch decisions made by pre-retiree (61+ years) super members were bad (up 8% from 64.2% in 2019).
From these findings, the paper suggests the need for increasing financial literacy and capability levels, protecting super members (at times from themselves), and improving access to quality financial advice.
We often can’t completely remove cognitive biases from our decision-making. However, we can seek professional financial advice to become more aware of, and properly evaluate, the influence and effect they can have on us. This can be coupled with improving our financial literacy and capability, and implementing an appropriate and regularly reviewed financial plan, which can include:
- setting clear and appropriate investment goals and objectives
- developing an asset allocation for our investment portfolio, which takes into account
- our financial situation, goals and objectives
- our tolerance and capacity to risk and investment time horizon
- the need to diversify our investment portfolio to avoid unnecessary investment risks
- committing to our investment strategy (and setting aside emotions) through times of investment market uncertainty, and notwithstanding, the actions of the investment market herd.
For more information about this topic, contact Carrick Aland’s Wealth Planning team on 1300 466 998 or visit carrickaland.com.au/wealth-planning/.
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