The Covid-19 crisis has shown us that humans hate uncertainty, and our brains rely on past experiences to try and create a more predictable world.
“These two interconnected neuroscientific realisations are very important from an investment perspective,” said Paul Nixon, head of technical marketing and behavioural finance at Momentum Investments.
“During times of high uncertainty, like we are experiencing now with Covid-19 and the extended nationwide lockdown, people are more predisposed to use their gut instincts and put critical thinking on the backburner. This puts us at risk of making decisions that could sabotage the success of our financial future.”
Nixon said that the human brain has a rule book to make the world more predictable.
“This rule book is essentially a belief system about how the world works. However, sometimes our brain will convince us of something that isn’t true, which is the essence of a cognitive distortion. This is because the brain is not necessarily looking for truth; it is looking for meaning,” said Nixon.
“Arising from past interactions with assumptions about the world, ‘unconscious inferences’ can lead to a visual precept that appears to differ from reality. Similarly, cognitive distortions stem from heuristics or thinking shortcuts.”
Applying this concept to an investment or advice scenario, Nixon said that, depending on what experiences and information clients have been exposed to in the past, they would have formulated belief systems around investing.
“Some of these belief systems may very well be false, such as the common misconception that past investment returns are a great way to select future investments.
“These belief systems are going to inform their investment choices going forward, but ultimately, when they don’t get the results that they desire, their willpower to stay invested for the long term will be tested.
“This only perpetuates the cycle, because clients will then start looking again for other investments options that have performed well in the past, switching course from their original plan.
“Unfortunately, even if proven unsuccessful, a belief system that has been developed based on past experiences is very difficult to change,” the behavioural finance lead said.
“As financial services providers, we are going to have to arm financial advisers with tools and diagnostic techniques that enable them to have the right conversations with clients around the psychological dimensions of financial planning.”
He also highlighted that “behaviour tax” is at its highest during times of extreme market uncertainty.
“A behaviour tax is the difference between the return an investor would have received if they’d stuck to their original plan, and the return they actually received as a result of their switching activity,” Nixon said.
Despite the heightened uncertainty Covid-19 has caused, Nixon emphasised that, as long as clients’ investment goals haven’t changed, their plans to reaching these goals should not be changing either. “The biggest cognitive distortion out there for investors right now is the market turbulence trap,” he said.
“When we look at our long-term investment goals through a short-term lens, we get the illusion of a lot more volatility and uncertainty.
“People have very short memories and, in a year or two, most will have completely forgotten how they were feeling during this time of uncertainty. In this sense, what remains most important now is protecting clients against cognitive distortions and keeping them invested in terms of their long-term goals,” Nixon said.