New Zealand Law Society - Do your money-making decisions make sense or do your emotions get the better of you?

Do your money-making decisions make sense or do your emotions get the better of you?

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Last time I talked about lawyers and their money personalities. We discovered the two most prevalent are the Family Steward and the VIP. This week I pose the question: Do you believe you always make rational decisions about money? Or does your Family Steward big heart rule your head? Or perhaps your VIP urges stomp on financial prudence?

You would expect lawyers to be rational thinkers, with critical thinking at the core of their legal occupations. However, on a personal level, lawyers are not immune to emotion and behavioural biases in their decision-making. The issue here is that our decision-making faculties are like lawn bowls – affected by bias and not just one. Many factors can skew an otherwise rational decision.

Overconfidence bias

When I interviewed 61 New Zealand lawyers about their money habits, overconfidence was the first bias tested in the survey. Overconfidence is overestimating or exaggerating one’s ability to successfully perform a particular task.

The survey indicated that 48% of respondents were likely to be susceptible to overconfidence, since they professed to have greater degrees of control over their investments (either directly or via their financial advisers). Overconfidence was less symptomatic in the remainder, who claimed little or no control.

Overconfidence can be one of the most detrimental biases that an investor can exhibit, often due to underestimating downside risk, trading too frequently and/or trading in pursuit of the “next hot share”, and holding a non-diversified portfolio. Overconfident investors often do not believe that the assets they traditionally favoured will ever perform poorly.

Survey respondents showing symptoms of overconfidence included lawyers who had turned fund managers or single-asset-class investors (predominantly property). One banking and finance lawyer who specialised in dealing with problems arising from overconfidence, said he was now more conservative when it came to investing.

Loss aversion bias

The loss aversion bias stems from the common rule of thumb that “psychologically, the possibility of a loss is on average twice as powerful a motivator as the possibility of making a gain of equal magnitude”. Essentially, loss aversion is the tendency for individuals to prefer avoiding losses rather than accruing gains. Many of the options we face in life are “mixed”; there is a risk of loss and an opportunity for gain, and we must decide whether to accept or reject the gamble.

I asked all participants the following questions to test for signs of emotional bias stemming from loss aversion.

Question: you have two choices

  • Option 1: A sure gain of $250,000.
  • Option 2: A 25% chance of gaining $1 million and a 75% chance of getting nothing.

Results showed that 79% of respondents chose option 1, and the remainder option 2. Our conclusion is that lawyers are less likely to take a risk to achieve an extra gain preferring to take the “bird in the hand” approach.

Question: you have two choices

  • Option 1: A sure loss of $750,000.
  • Option 2: A 75% chance of losing $1 million and a 25% chance of losing nothing.

Results showed that 75% of respondents chose option 2, and the remainder option 1. This led me to the conclusion that lawyers are more likely to take a risk to avoid a loss.

Risk aversion bias

I anticipated that lawyers, like most other people, would prefer a certain gain or to take a risk to avoid a bigger loss so there were no real surprises in the survey results. I also wanted to explore how they perceived their attitudes towards risk. Logically, I had expected a “conservative” response to investing risk, as many had indicated exactly that. The responses below may surprise.

I asked them, “How do you feel about taking risks? Very comfortable, somewhat comfortable, conservative or very conservative?” Close to half, or 43%, ranged from conservative to very conservative, while a majority of 57% saw themselves as somewhat comfortable, through to very comfortable, with risk.

It is difficult to reconcile these results with expectations and the loss aversion responses. Some found it difficult to limit their choice to only one option. One outlined his attitude to risk as “schizophrenic”. He had investments that were very conservative, alongside highly speculative business interests, such as high-risk ventures and start-ups. Another described himself as “a man of two extremes” with conservative investments (mainly in property) “safely tucked away”, but with a large number of lavish lifestyle assets.

Several others identified themselves as conservative, with investments in only one asset class, property. While acknowledging that this may not be a good financial strategy, they nonetheless considered the investments conservative. Such property holdings often don’t provide an income, since they are lazy lifestyle assets, such as a family bach. Many also mentioned that most of their property investments were leveraged through debt, which is also not a very conservative strategy.

The lawyers who identified themselves as very comfortable with risk once again tended to be banking or property specialists. Those who had moved out of legal services to become property developers or fund managers also believed investing was their area of competence.

Hindsight bias

The hindsight bias is the tendency to see events that have already occurred as being more predictable than they were before they took place – the “I knew it all along” impulse.

The hindsight bias is difficult to measure because people are rarely aware that they are affected by it. I looked for clues to potential hindsight bias, through a question with two options relating to the natural reaction to the situation faced when an investment had failed. Under option 1, they would generally not fault themselves. Under option 2, they would want to investigate the situation and determine why the investment had gone wrong.

43% chose option 1, exhibiting symptoms of hindsight bias. A majority of 57% chose option 2, which does not hint at hindsight bias. The tendency of lawyers to want to analyse and understand the situation reflects their analytical approach and enquiring minds, as well as a desire to learn from the past to avoid repeating the same mistake in future.

Availability bias

The availability bias is a rule of thumb that allows people to guess the probability of an outcome based on how that outcome appears in their lives. Very few identified with such symptoms. However, some discussions about investments hinted at the availability bias, along with symptoms of other biases not tested directly in this survey.

One issue mentioned regularly by lawyers in large law firms was their inability to invest in shares, due to insider-trading rules. Believing that, as advisers to many listed companies, they were exposed to insider-trading risk, they delegated management of their share portfolios to third parties. While this is prudent, such explanations showed an element of availability bias, as they seemed to infer that by advising some New Zealand listed companies, they were involved in the whole market and could not make any direct investment decisions themselves.

Familiarity bias

Many New Zealand investors face the familiarity bias, since they tend to overweight their investments in the 50 stocks making up the NZX 50 Index, often only investing in the top segment.

The recurring client-focused tendency of lawyers to want to support their clients’ businesses where possible is an example of the familiarity or availability bias. One lawyer in several governance roles felt a moral obligation to support the projects he was involved with at board level. He had therefore bought shares in the initial public offerings of those companies.

It is very common for investors around the world to show a bias in their portfolios towards their home markets, overweighting companies and sectors close to home and with which they are familiar. One property lawyer invested solely in property for this reason. However, restricting investments to his area of competency also significantly limits diversification and creates concentration risk. He acknowledged the familiarity bias and the fact he had made “bogey” decisions, despite his professional expertise.

Herd instinct bias

Closely aligned with the familiarity and home biases is the heuristic herd instinct bias. This mentality is characterised by a lack of individual decision-making or thoughtfulness, causing people to think and act the same way as most of those around them. Gravitating towards the same or similar investments as others is a pointer to this bias. The media is a common platform for the herd instinct bias. More than one lawyer acknowledged following newspaper columns and share tips. Another referred to the influence of “billionaire friends” in introducing him to high-risk ventures. He participated without realising the disproportionate effect such investments would have on his much smaller portfolio.

No one has a crystal ball as to which asset classes will outperform at any given time. All we know is that in the long run, investors are rewarded for risk-taking – diversifying investments across different global asset classes maximises returns while minimising risk. This is the essence of diversification and “efficient” markets.

The battle of the biases

As discussed, a number of powerful biases will directly or indirectly affect your ability to make a rational decision where your money is concerned. Knowing what they are will make it much easier to fight their influence. As Chinese military general, strategist and philosopher Sun Tzu is often quoted: “If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained, you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle”.

Now that you have a better understanding of your Family Steward and VIP money personalities and the bias range that can taint your ability to make rational money-making decisions, you are another step closer to being financially fighting fit.

Laetitia Peterson is a personal wealth adviser and is married to competition barrister Andrew Peterson. She has worked with companies such as Goldman Sachs and boutique funds management firm Liontamer, which she co-founded with Janine Starks. She is now the CEO (and founder) of The Private Office, helping successful lawyers achieve the financial goals important to them and their families. Laetitia’s book Legal Tender explores the ideas of family stewardship, typical money behaviours, attitudes towards money, and lawyers’ views on wealth creation.

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