Investors who have been in the market for a long time know that investing is an emotional activity as much as it is a financial activity. This is the reason that people who have a higher degree of self-control generally tend to do better than their peers. Self-control bias may seem like an obvious and simple flaw. However, it has a profound effect on the behavior of any investor. The details of the self-control bias have been listed below:
What is Self-Control Bias?
Self-control bias stems from a behavioral flaw called hyperbolic discounting. As per hyperbolic discounting, there is an inherent flaw in the way investors perceive gains. They have a large appetite for short term gains. However, if they are asked to sacrifice short term gains for long term gains which will be much bigger, most will still choose the short term gains. Hence, investors have a skewed time preference, which negatively impacts their decision making. In simple words, investors with this bias are inclined towards spending more today at the expense of saving less for the future.
Self-control bias is not only seen in the financial world. It is also seen in the other walks of our daily life. For instance, people may be unable to lose weight despite knowing that it is in their best long term interest to do so. They may continuously choose to eat unhealthy food despite knowing that it will cause harm to them.
How Does Self Control Bias Impact Financial Decisions?
- The first thing to note about self-control bias is that people with this bias have a smaller portfolio size. This is because they may prioritize frivolous monthly expenses over long term retirement savings. Hence, they either start investing late or invest a smaller portion of their income.
- Their portfolio size and savings rate may be small, but they tend to have lofty goals. This is the reason that people with self-control bias often tend to undertake risky investments. This is done so that they can meet their goals with smaller investments. However, here too, their self-control bias comes into play. They tend to overvalue the immediate gains arising from the risky investments and undervalue the long term impact that the additional risk can have on their portfolio.
- People with self-control bias tend to prefer investments that have shorter lock-in periods. Often, this means that they ignore some better investment proposals only because it means that their money will be locked in for a longer period of time. People with self-control bias feel that they should be able to spend the money in the near future. They do not have a long term outlook.
- Another important point about people with self-control bias is that they tend to prefer investments that give a monthly income. The problem with this approach is that as soon as they are paid their monthly dividend, they are likely to spend it all. The true value of any investment can only be realized if it is allowed to compound for an extended period of time. However, if the investor with the self-control bias keeps on obtaining their dividends, they are likely to spend it. Hence, they may never be able to gain from the compounding power of their investments.
- In many parts of the world, self-control bias is used to justify making consumption purchases such as real estate in the name of investment. The reasoning given is that it is better to have a large mortgage payment. This is because, in the absence of a mortgage payment, the investor might just spend all the money and not be left with anything. However, the investor fails to take into account that initial mortgage payments are mostly made up of interest payments. Hence, their forced savings plan is not causing them to save money at all! The fear and lack of confidence cause investors to make irrational decisions.
How to Manage Self Control Bias
- People who have self-control bias must make attempts to get rid of this bias from its roots. This means that they should firstly concentrate on their savings goals. This often means that they need to rationalize their spending.
- Investors with self-control bias often do not have an investment plan. Instead, their investment decisions are a bunch of ad-hoc decisions that are made in the spur of the moment. The reality is that in the financial world, failing to plan equals planning to fail.
- Investors with self-control bias must be sensitized that it is important to have realistic assumptions. Their portfolio allocation should not be made based on their risky decisions. Instead, a scientific approach should be followed to decide their debt-equity mix based on the stage of life that they are in.
The bottom line is that self-control bias is not small or frivolous. Like other behavioral biases, this bias also has a huge impact on the portfolio of the investor as well as the return that they gain from it.
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- Behavioral Finance - An Introduction
- Heuristics and their role in Finance
- Advantages of Behavioral Finance
- Limitations of Behavioral Finance
- FAQs About Behavioral Finance
- Prospect Theory
- How Loss Aversion Affects Investment Decisions
- The Sunk Cost Fallacy
- The Endowment Effect
- Regret Aversion Bias
- Self-Control Bias
- Anchoring Bias in Behavioural Finance
- Confirmation Bias in Behavioral Finance
- Herd Mentality Bias
- Mental Accounting
- Recency Bias
- Overconfidence Bias
- Conservatism Bias
- Framing Bias
- Behavioral Portfolios
- Hindsight Bias
- Illusion of Control Bias
- Status Quo Bias
- Sample Size Neglect
- Optimism Bias
- Cognitive Dissonance Bias
- Home Country Bias
- Availability Bias in Behavioural Investing
- The Bias Blind Spot
- The Narrative Fallacy
- The Planning Fallacy
- Base Rate Fallacy
- Contrarian Investing
- Cultural Influences on Financial Decisions
- Behavioral Life Cycle Theory
- The Barnewall Model
- Bielard, Biel and Kaiser (BBK) Model
- Three Dimensional Pscychographic Model
- Categorizing Behavioral Biases
- Lessons Learned in Behavioural Finance