- Financial psychology is a discipline that is often neglected and fills the space between psychology and behavioral economics.
- And if we understand how the financial climate affects us, instead of being influenced by it, we can better control our cash, transforming us into more responsible investors, more productive savers, or less impulsive shoppers.
- The vast majority of traders—82 percent—ended up losing money, and the average result was a $2,870 loss.
- Visit The Financial Today’s homepage for more stories.
Financial psychology is a discipline that is often neglected and fills the space between psychology and behavioral economics. It’s well known to advertisers and marketers seeking to persuade us to spend money—and customers will eventually benefit from taking the time to understand it.
And if we understand how the financial climate affects us, instead of being influenced by it, we can better control our cash, transforming us into more responsible investors, more productive savers, or less impulsive shoppers. It may also help us understand harmful trends, such as addictive consumption or debt problems, and the underlying issues that can cause problematic financial behavior.
In this six-part series, we are going to examine six financial personality types to help you identify some common traits and biases you might unknowingly possess.
The Overconfident Trader
Greg Davies, who in his former position as head of a specialist behavioral finance unit at Barclays researched the trading habits and financial personalities of thousands of retail investors, says this personality trait is extremely popular among affluent investors.
“They overtrade and have an action bias, which is a tendency to want to do things instead of not do things,” he says. “They often buy high and sell low as they are more comfortable with risk when things are good, and remove risk when times feel bad.”
Davies, who has since launched consultancy Centapse, says such people tend to underperform the buy-and-hold investor “by 1.5 percent to 2 percent year” based on his analysis.
“I have also measured such people’s belief in their own skills,” he adds. “Many have absolutely no idea what their returns actually were and only remember their good decisions.”
Harold Evensky, chairman of US financial planning firm Evensky & Katz, says that in his almost four decades of experience, most clients who trade frequently tend to get things wrong.
“The day trader or hobby trader is someone who typically exhibits an extreme level of overconfidence,” he says.
This is borne out by recent data on investors taking out leveraged “contracts for difference” collected by the UK financial regulator on spread betting websites. The vast majority—82 percent—ended up losing money, and the average result was a $2,870 loss.
A 2011 research by academics at the University of California found most individual traders underperform standard investment benchmarks. One reason was that they were trading instinctively rather than strategically, and “repeating past behaviors that coincided with pleasure while avoiding past behaviors that generated pain”.
Financial markets can become an addictive environment. “Trading fires up the pleasure centers in the brain,” says Davies. “The longer you stay in an addictive environment, the more prone you are to bad decisions, which causes anxiety, which leads to overtrading and therefore more anxiety.”
What can you do to break this damaging habit? He suggests that traders should write their own rules before starting, and stick to them. “Have a plan, use stop losses, have rules on when and how you rebalance a portfolio,” he advises. “I call this decision-making prosthetics. Not an artificial limb, but an artificial way of making better decisions that we impose on ourselves.”
The solution for Evensky is simpler: either stop, or restrict your trade to a limited sum of ringfenced cash that you can afford to lose. Try using some of the saved money to hire a financial planner to help you arrange your financial goals for the long run.