Ways Your Brain Can Undermine Your
Investing
It
does not matter how rational we think we are. The chemicals in our brains often
lead us to make irrational decisions. This affects all of our decisions,
whether in our social life or our investment portfolio. Behavioral Finance
is the booming field of study aiming to reconcile the discrepancy between
rational valuation and irrational market pricing. Below are some of the common
behavioral biases that can lead to bad investment decisions.
5. Anchoring:
Investors are bad at processing new information - Anchoring is
related to overconfidence. For example, you make your initial investment
decision based on the information available to you at the time. Later, you get
news that materially affects any forecasts you initially made. But rather than
conduct new analysis, you just revise your old analysis. Because you are
anchored in the old thinking, your revised analysis will not fully reflect the
new information.
Representativeness:
Investors connect the wrong things to one another - A company might
announce a string of great quarterly earnings. As a result, you assume the next
earnings announcement will probably be great, too. This error falls under a
broad behavioral-finance concept called representativeness: You incorrectly
think one thing means something else. Another example of representativeness is
assuming a good company is a good stock.
Loss
aversion: Investors absolutely hate losing money - Loss aversion,
or the reluctance to accept a loss, can be deadly. For example, one of your
investments may be down 20% for good reason. The best decision may be to just
book the loss and move on. But you can't help thinking the stock might come
back. The latter thinking is dangerous because it often results in you
increasing your position in the money-losing investment. This behavior is
similar to the gambler who makes a series of larger bets in hopes of breaking
even.
Regret
minimization: Investors have trouble forgetting bad memories - How you trade
in the future is often affected by the outcomes of your previous trades. For
example, you may have sold a stock at a 20% gain, only to watch the stock
continue to rise after your sale. And you think to yourself, "If only I
had waited." Or perhaps one of your investments falls in value, and you
dwell on the time when you could have sold it while in the money. These all
lead to unpleasant feelings of regret. Regret minimization occurs when you
avoid investing altogether or invest conservatively because you don't want to
feel that regret.
Frame
dependence: Investors like to go with the flow - Your ability to
tolerate risk should be determined by your personal financial circumstances,
your investment time horizon, and the size of an investment in the context of
your portfolio. Frame dependence is a concept that refers to the tendency
to change risk tolerance based on the direction of the market. For example,
your willingness to tolerate risk may fall when markets are falling.
Alternatively, your risk tolerance may rise when markets are rising. This often
causes the investor to buy high and sell low.
Citations
Thanks,
D Cory Payne
Beehive Insurance Retirement Planning Services
302 West 5400 South #101
Murray, Utah 84107
801-685-6875 Direct
801-554-7797 Mobile
801-685-2899 Fax
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