A similar phenomenon can happen in finance, but instead of being exhausted from a lack of sleep, you may be making your future self poorer.
This phenomenon occurs because people tend to be so nervous about short-term losses that they do not take the risks that come with growing their wealth over time. This fear becomes particularly acute during times of investment market turmoil, as we’ve seen since the start of the year.
This fear is understandable. Thanks to high-profile geopolitical issues, investment markets have suffered volatility. This is worsened by the 24/7 media coverage of such events and the fear that is spread on the back of it.
This was not because of any economic crisis, but simply because there had been some erratic policymaking from the US Government.
However, much of the market turmoil, which was especially acute in April, has now normalised , with major indices now back above where they were to begin with.
If we take a bigger picture historical view of similar events, even major hiccups in markets, such as the Global Financial Crisis or Covid, appear only as minor setbacks in the long-term progress of investments.
Opportunity cost explained
‘Opportunity cost’ is the value of the next best alternative an individual gives up when choosing in everyday life. For instance, if you spend an hour watching TV, the opportunity cost might be the exercise, work, or time with family you could have prioritised instead.
In daily situations, resources such as time, energy, or money are limited, so every decision means sacrificing something else. Choosing to buy a new phone might mean giving up a weekend away. Understanding opportunity cost helps individuals weigh trade-offs and make intentional choices that align with their priorities.
In investing, opportunity cost is the potential return missed by choosing one investment over another. If you put money into a cash savings account for its supposed safety, the opportunity cost could be the higher returns from investments or other assets.
With limited capital, every investment decision sacrifices other possibilities, like diversification or liquidity. By considering opportunity cost, investors can better evaluate whether their choices maximise growth or align with their financial goals, ensuring they don’t overlook more promising alternatives.
Behavioural science
This phenomenon is so hotwired into human nature; there is a whole branch of behavioural science devoted to it. ‘Loss aversion’ is commonplace. This is where an investor places greater weight on concern for losses than they derive pleasure from making gains. Their instinct to avoid losses means they make poor decisions, prioritising comfort today over long-term gains.
There are other, related, behavioural phenomena that hold investors back. For example, familiarity bias is when investors tend to gravitate to investments they know and feel comfortable with. While there is nothing inherently wrong with that, it can lead to concentration in specific regions or sectors. This can leave portfolios unprotected should a single sector have a wobble.
An ‘experiential’ bias is when investors let recent events sway their judgement and fail to put those events in context. This may make them less inclined to invest in the immediate aftermath of the financial crisis or the Covid pandemic, as they believe these events are more likely to recur (though they aren’t, for valid reasons).
How can investors ensure the fears and biases of their current self do not affect the fortunes of their future self? Recognising the phenomenon exists may be the first hurdle. If you know what you’re doing, you have a fighting chance of stopping it in its tracks.
It can also help to impose some discipline around your savings, like saving regularly helps to avoid the highs and lows. If you invest monthly, rather than putting a single lump sum to work in one go, you may avoid some of the volatility associated with stock market investing. You’ll buy in at a series of different price points, which helps minimise the risk of putting it all in the market at its highest point.
It’s also important to invest for the long term. Stock market investment usually needs a time horizon of at least five years, and, as far as possible, you need to avoid tinkering with it in the interim.
Studies repeatedly show that investors are bad at timing the market, tending to buy in and sell out at the wrong time. If your current self can ignore the market’s gyrations, think long-term and make regular investments, your future self should be very grateful.