Financial Decision Making Under Uncertainty
When faced with uncertain times, we are often our own worst enemies when it comes to financial decision making. We tend to act impulsively, follow the herd and fail to think through the consequences of our actions. A significant amount of behavioural science research has focused on how we make decisions under uncertainty. I think everyone would agree that we are currently facing one of the most uncertain times in living memory and around the world people are having to adjust to a new normal that is so different to just a few months ago. The scale of this pandemic means that it's important to understand how we respond to this uncertainty and what psychological pitfalls may be working against us during this time.
When we are faced with uncertainty and forces beyond our control, we often take action to gain a semblance of psychological control over the situation even if the actions we take may actually be detrimental. This is called Action Bias and we can thank evolutionary biology for this psychological pitfall. We are hard wired to value action over inaction as the primary producer of value and survival. As an ardent soccer fan, the best way to explain and conceptualize this would be to think of goalkeepers when facing a penalty.
Statistics are very clear when it comes to goalkeepers facing penalties: you have the best chance of saving a penalty if you remain in the middle of the goal. Despite this, most goalkeepers dive to either the left or the right. The Action Bias is actually at play here that influences goalkeepers to move to either side instead of staying in the middle. The reason is twofold. Firstly, the penalty is a statistically lopsided contest: A goalkeeper has to defend 8.5 square metres of area from a shot taken from 10 metres away at upward of 125 kilometres per hour. So, it shouldn't come as a surprise that most penalty kicks result in a goal. Goalkeepers tend to dive to either side of the goal rather than standing still because their movement creates a psychological comfort zone for them and helps them believe they can maintain some semblance of control in an unbalanced interaction. Fans would also judge a goalkeeper very harshly should they not dive and the kick result in a goal meaning we all tend to value action over inaction.
The Action Bias is one example of investor behaviour that is characterised by irrational, emotional and reactionary decisions. Countless studies have shown that when the stock markets go up, investors put more money in it and when the markets are down, they take their money out. If you think about it, this is similar to buying something at the shops when the price has gone up and wanting to return it when it is on sale, but the amount you get back is the sale price and not what you initially paid.
We tend to overreact to all news be it good or bad which leads to poor investment choices. We also overestimate our ability to predict future events and we allow our emotions to dictate our decisions. There are a few ways you can avoid making an impulsive decision during an uncertain time. Firstly, contact your financial advisor to review your portfolio. If you do not have one, now would be the perfect time to enlist their services. A financial advisor can be a protective barrier between your emotions and decisions.
Despite our bias towards action, we need to come to the understanding that a thoughtful decision to do nothing is a legitimate form of action. Markets recover; we have seen examples of this with the dotcom bubble burst in the early 2000s and the sub-prime mortgage crisis in 2008. If your financial portfolio was structured around your long-term goals, a change in the markets shouldn't influence you to stray from that path.
Another irrational behaviour that is manifesting itself during this pandemic is people cancelling their insurance. Behavioural science offers an explanation as to why. The benefits to insurance are often intangible and as a result we tend to view them less favourably than other things which offer immediate, tangible value. Insurance is all about being prepared for a future eventuality which we consistently undervalue. This is called hyperbolic discounting and refers to the act of prioritising something in the moment at the expense of your future utility. For example, spending frivolously now at the expense of saving for your retirement. Just because an event will take place in the future doesn't give it less importance and mean it should be deprioritised. Hyperbolic discounting is why so many South Africans are underinsured when it comes to their life cover, why only 1 out of every 4 cars are insured and why only 6% of South Africans are adequately prepared for retirement.
Ironically, these times of uncertainty are exactly what insurance was designed for. The very essence of insurance is to protect yourself against events that may be certain but may occur at uncertain times. One of the best examples of this comes from the UK. Wimbledon are set to receive a £114 million pay-out as they have had pandemic insurance for the last 17 years. They were prepared for an eventuality they considered likely even if the time it would occur was somewhat uncertain.
Another reason people are cancelling their insurance is that we often fail to think through the consequences of our actions. Cancelling your insurance can have significantly negative effects on your life that far outweigh the immediate benefit. Not only could it leave you without protection should something happen, it could also raise future premiums when you try and take it out again as well as reset your waiting periods for things like life insurance. Rather than cancelling, ask about the relief measures that have been put in place that have been designed to help you in the short term and won't negatively impact you in the longer term.
Think about your future self, it can even be a few months or a year from now. Think about what decisions your future self will thank you for and which decisions will cast a shadow of regret. Now is the time to remember your long-term goals when it comes to investing and saving for retirement. Now is the time to remind yourself why you took insurance in the first place – to protect yourself against life's predictable uncertainties. Even though we are faced with uncertainty, it doesn't invalidate your previous decisions. Make the choices now your future self will thank you for and whatever you do, don't be a goalkeeper.