[Podcast] Why Rational People Like you Make Irrational Investment Decisions

Are you where you want to be financially?

If not, what’s holding you back?

That’s what we’re going to talk about in today’s show. 

Are you where you expected to be at this stage of your life?

Would you like to move further?

If you’re like most Australians, you’re probably not where you expected to be financially.

Even if you’re doing well, understanding behavioral finance can help you do better.

We make thousands of decisions every day.

We usually make these decisions with almost no thought, using heuristics – rules of thumb.

This can lead to predictable errors in certain circumstances.

For example, we’re naturally biased toward selling investments that are doing well but holding onto those that are doing poorly. 

Behavioral finance is the study of the dozens of financial decision-making errors that can be avoided if you know what to look for.

The world is complicated, and if we had to make a perfect decision every time, we’d be so bogged down that we’d never do anything.

So we’ve evolved to have cognitive biases that function as kind of a shortcut to help us make decisions that are often right in the short-term.

Some of these cognitive biases could be standing between you and property investment success:

•      Confirmation Bias: The tendency to search for information that confirms your view of the world and ignore what doesn’t fit. Confirmation bias also prevents us from looking objectively at an investment we’ve already made. Once we’ve bought a property we look for information to confirm that we’ve made a good investment while as the same time ignoring information that may indicate the investment may be a questionable one. 
•      Anchoring Bias: The tendency to use anchors or reference points to make decisions and evaluations, even though sometimes these lead us astray. The first number you see, especially when it’s a price that comes up in negotiation, colours any that come after it. A high anchor influences you to spend more than you normally would. Whether we like it or not, our minds keep referring back to that initial number, and perceive any subsequent offers as being a discount or a deal, even if they’re objectively still too high.
•      Awareness Bias: There’s a chance that even if your investments are not doing so well, you may not even recognise it. it’s been shown the poorest performers in all arenas of life are the least aware of their own incompetence. Lacking the capacity to realise how badly a task is performing is known as the Dunning-Kruger effect.
•      Positivity Bias: Many people view residential real estate positively, considering it an asset class through which they can grow their wealth – and they continue to do view it in this light, even if their investments fail to prosper. Positivity bias can stand in the way of an investor taking action to rectify the situation. 
•      Negativity Bias: Just as some investors can be overly positive this is the tendency to put more emphasis on negative experiences rather than positive ones. People with this bias feel that ‘bad is stronger than good’ and will perceive threats more than opportunities in a given situation.
•      Status Quo Bias: This describes our tendency to stick with what we know, whether or not it’s the best course of action. Psychologists call this “loss aversion” and it explains why so many Australians are willing to stick their money in a plain old bank account earning minimal interest, rather than taking the “perceived risk” of a property investment.
•      Survivorship Bias: The misconception here is that you should focus on the successful if you wish to become successful, while the truth is that when failure becomes invisible, the difference between failure and success may also become invisible. The trick when looking for advice is to not only learn what to do, but also look for what not to do.
•      Bandwagon Bias: This is the psychological phenomenon whereby people do something primarily because other people are doing it. This tendency of people to align their beliefs and behaviours with those of a group is also called “herd mentality.” 
•      Restraint Bias: Following on from bandwagon bias, restraint bias is the tendency for people to overestimate their ability to control impulsive behavior. Psychologists say the very people who think they are most restrained are also most likely to be impulsive.
•      The Ostrich Effect: When an ostrich is scared, the bird supposedly buries its head in the sand to stay ignorant of the approaching threat. While we simply don’t have the neck length to literally stick our heads in the sand, people often deliberately look away from their money problems.
•      Choice-Supportive Bias: This is the tendency to prefer the things you own (even if they have flaws) over the things you don’t, because you made “rational” choices when you bought them. You may be convinced the investment you’ve just made is great because you spend so much time, research and emotion in selecting it. You rationalize your past choices to protect your sense of self.
•      Clustering Illusion: This is the tendency to see patterns in random events. This selective thinking can lead to wrong conclusions when faced with the multitude of mixed messages we receive about the property market. 
•      Curse of Knowledge: You suffer from the curse of knowledge when you know things that other people don’t and you’ve forgotten what it’s like to not have this knowledge. Highly  intelligent people often have difficulty asking for help or taking advice because they think they should be able to work things out for themselves.
•      Overconfidence: One of the worst things that can happen to an investor is to get it right the first time they buy a property. This often happens when you invest during a property boom because you tend to think you’re smarter than you are. The best defense against this is to continue to ask questions and be skeptical of your preconceptions.
•      Procrastination: Of course, we all procrastinate at times, but in the arena of property investment those who sat on the sidelines over the last few years waiting for the investment horizon to look clearer, have missed out on some fantastic opportunities.
•      Hyperbolic Discounting: This is the tendency for people to prefer smaller payoffs now over larger payoffs later, leading one to largely disregard the future when it requires sacrifices in the present. 
•      Hindsight Bias: This is the tendency for people to overestimate their ability to have predicted an outcome that could not possibly have been predicted. hindsight bias matters because it gets in the way of learning from our experiences because if you feel like you knew it all along, it means you won’t stop to examine why something really happened. Hindsight bias can also make us overconfident in how certain we are about our own judgments.
•      Illusion of Control: Illusion of control is the tendency for human beings to believe they can control or at least influence outcomes that they demonstrably have no influence over. In property it’s the concept that you think you’ve got all your risks covered. In my mind risk is what is left after you’ve thought of all the things that can go wrong.
•      Information Bias: This is the tendency to seek information when it does not affect action. More information is not always better. Indeed, with less information, people can often make more accurate assessments because too much can lead to analysis paralysis. 
•      Post-Purchase Rationalization: This is what happens when we buy something that turns out not to be up to standard. Yet, we want to believe that we didn’t waste our resources, so we try to rationalize the purchase. This happens much more often with impulse buys than with carefully planned investment decisions.
•      Skill Bias: There is so much information and education available to investors that many people feel they are qualified to make significant financial decisions, despite the fact that they have no experience to back them up. This can lead to unfortunate shortsighted decisions, which can be very costly if the properties fail to perform as you’d planned.
•      Personal History Bias: Research shows that the way you feel about a topic is generally pervasive and was most likely shaped by events experienced in your youth. These influences will show in the risks they are willing to take and the investments that appeal to them.
•      Bias Bias: This is probably the most important bias of them all – the belief that you are less biased than you really are. If you listened to the whole show without realising I’m talking about you, you’re suffering from bias bias.

Links and Resources:

Michael Yardney

Metropole

Rich Habits Poor Habits

Michael Yardney’s Mentorship Program

Some of our favourite quotes from the show:

“So, the first step to make better investment decisions is to become aware that we’re currently making bad decisions.” – Michael Yardney

“When we make decisions that are biased, what we’re doing is trading off some version of the right decision for a comfortable decision today.” – Michael Yardney

“The truth is that when failure becomes invisible, the difference between failure and success may also become invisible.” – Michael Yardney

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