fxmatters

The decision to buy or sell financial assets is invariably complex. It concerns an unknown future, it concerns a past of ambiguous cause and effect, there are multiple factors present, and you are trying to second-guess the actions of others. We have a few tricks up our sleeve to help – or hinder – these decisions.

Actions are not taken without emotions. Without emotion we tend to not act. At other times, optimism or fear drives us to act impetuously. One way this manifests itself is to react inordinately to everyday small risks while neglecting the longer-term, more extreme risks; for example worrying about what the share price is today or tomorrow rather than addressing the wider issue of what happens if I don’t build up a nest-egg for retirement. One remedy is to vividly describe bad and good long-term consequences of various long-term average returns, and then address whether any action is required now.

We prefer consistency. This can be a good thing, but not if you are wrong. Unfortunately we tend to subscribe to evidence that supports our view of markets, and tend to reject contradictory evidence. This trait presents a particular challenge in financial markets where cause-and-effect is often episodic. What worked in earlier decades may be different today e.g. the NZD/USD reverted to average within 18 months years of previously reaching 70c in the 1980s and 1990s; this time we are four years into ‘over-valuation’.

We are easily influenced by what we see. The literature talks of anchoring. The value you ascribe to a house is typically influenced by the vendor’s asking price. There is also the issue of using readily-available information: we tend to draw on our recent experiences to shape decisions e.g. I’ve lost money on Telecom in the past so I will not be buying it again (irrespective of what new information may be at hand).

We are what we expect to be. Well, sort of. At least there is a tendency to act according to our expectations of ourselves: hypothetically choose to donate to charity, and we are more likely to actually donate when the real request comes. In markets if we think through what we might do when a share price rises or falls, we are more likely to act accordingly when the time for decision comes e.g. act like a long-term investor or a short-term trader.

We don’t like losing. In fact, we dislike losing more than we like winning. Thus we tend to avoid risk when we feel we are onto a ‘sure-thing’ (even if ‘sure’ is only highly probable) and we seek risk when faced with a highly probable loss. Traders will recognise this as the temptation to ‘double-up’ when in a losing situation. It also occurs, less obviously, when dealing with extreme risk: for low-risk, far-away events such as ill-health or a large disadvantageous NZD movement we will tend to accept the risk, especially if we perceive the cost of insurance or a currency option as a ‘loss’ in the short-term.

Words are important. We react to primitive concepts such as family, honour and fairness. So returning to the above ‘insurance’ example, we are more likely to connote hedging with safety and good sense if we frame the decision as one of insurance. This terminology will also ease the wider acceptance within your organization of the inevitable ‘negative cash flows’ that will occur, events that are not easily recognizable as of value at the time to others (with the benefit of hindsight).

The short of it all is that we are human. We use emotions when we make decisions. And we draw on what we know. These are not necessarily bad traits but it is worthwhile taking our behavioural tendencies into account when making financial decisions. If nothing else, be clear in your investment goal and think longer-term.