Why Investors Make Decisions That Contradict Best Investment Practices

On July 27th, 2011, posted in: Economic News by

There are measurable psychological factors of behavioral finance which help explain why investors often make buy and sell decisions that contradict the best investment practices.

Loss Aversion: Expecting high returns with low risk – Loss aversion causes the investor to search for investments that don’t exist and results in either taking no action or later discovering that the selected investment fails to meet the expectation. The effect is often selling the investment at an imprudent time and losing alpha. (Alpha is any gain above the benchmark).

Narrow framing: Making decisions without considering all implications. The result is quick decision making with the consequence that facts are uncovered after inappropriate investments are made. Investors make precipitous investment changes, which can lose alpha.

Anchoring: Reacting to familiar experience, even when inappropriate. Anchoring is a very powerful communication method but can mislead investors unless it is used with caution. For example, investors can be misled about the stability of an investment if analogies are used to represent stability. Analogies of growth can also lead to unrealistic beliefs and explanations. Alpha can be lost by selecting an investment that cannot reasonably be expected to reduce the expected alpha.

Mental accounting: Taking undue risk in one area and avoiding rational risk in others. Used wisely, mental accounting can permit an investor to achieve high alphas in one area while protecting assets for other purposes. Imprudent use of mental accounting can be as damaging to alpha as any other psychological factor since investors can be misled into inappropriate investments.

Diversification: Seeking to reduce risk by simply using different sources, giving no thought to how such sources interact. This extremely valuable investment strategy can also be misused to create a false sense of protection that results in alpha killing actions.

Herding: Copying the behavior of others even in the face of unfavorable outcomes. Investors that go along with the crowd simply because there is a crowd, tend to avoid catastrophic errors but seldom achieve above average returns. Alpha is not achievable with herding.

Regret: Treating errors of commission more seriously than errors of omission. Investors who fear decision making lose through inaction or reversals. Inaction can prevent losses caused by poor decisions, but is unlikely to produce alpha.

Media Response: tendency to react to news without reasonable examination. Familiar media sources have become less reliable as they compete with newer, faster and lower cost outlets. At the same time, news media outlets seldom have very thorough authentication. This question of reliability raises the concern about reacting to news at all.

Optimism: Believing that good things happen to “me” and bad things happen to “others.” Optimistic investors hold on to investments after it becomes evident that losses are not likely to be recovered. Holding on to poor investments is yet another way psychological factors can lose alpha.

KEY QUESTIONS

  1. Do you believe that an investment under consideration produces a return with little risk? Are you aware of the risks?
  2. Have you considered what it will mean to you to commit to this investment for x years if you should need the money?
  3. The illustration that was used is not literal; do you see how it differs from real life investing?
  4. Do you have a specific purpose in mind for each investment portfolio that you own? Do you know how much risk you are willing to take with each one?
  5. Do you know whether you have the same underlying investment in different portfolios? Does that mean that you have excessive exposure to that underlying investment?
  6. Have you heard from others that the investment under consideration is a good one? How many people have recommended it? Would you consider these people to experts? Are the recommendations based on your personal situation?
  7. Do you expect the value to decline the day after you make an investment? If the investment does decline, will you withdraw your funds?
  8. Have you seen recent news reports or stories that relate to the investment under consideration? Have those news reports made you more or less inclined to own the investment under consideration.
  9. Have you considered the changes that have occurred since your decision to make the investment under consideration? Would it be wise to put some of the profits you have made into a more secure investment?

 

This information is compiled by Guy Baker from an assortment of news feeds including First Trust, Yahoo Finance, Bloomburg and others. This information is intended to be informational only. This newsletter contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Investing involves risk, including the potential for loss of principal. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.

 

 

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