The Big Secret Behind Your Poor Investment Decisions
All of us make illogical and irrational decisions. It’s part of being human.
This can however, have big negative consequences in our personal lives.
Moreover, this nonsensical tendency can also creep into our finances – often leading to detrimental or even disastrous results:
- Pulling all your money out of a particular stock or fund when the market falls, rather than waiting for things to level and climb back up again, which they usually do.
- Putting too much money in one seemingly attractive, “guaranteed high returns” investment opportunity, rather than spreading the risk out. (I.e. not putting all your eggs in one basket).
- Speculating too much money on a single unproven investment.
And so on.
We are financial advisers in Nottingham, and we encounter these investment tensions and biases all of the time. It’s our job to identify them and counteract them, in order to help our clients make sound financial decisions.
It always helps, moreover, to equip our clients with the tools to help them recognise human investment biases. It will help you in your long-term investing and financial planning, as well as when dealing with day-to-day finances.
The Secret Behind Our Irrational Decisions
According to Prospect Theory, the pain of financial loss is twice as painful for humans as the rewarding feeling from financial gains.
In addition, when we give financial advice we often talk about the concept of “hyperbolic discounting”. This means that people tend to prefer smaller, more immediate rewards than larger more distant ones.
This is not an ideal disposition for an investor! Indeed, it is very much back-to-front to how things should be, and it leads to emotional “ups” and “downs” where we focus on the wrong things.
Here’s an example of an imaginary investor, showing how easy it is for short-term losses to influence our financial decisions:
George watches one of his investments on the market. The price is steadily rising, and he wants to profit from the trend. So he buys more. It goes up slightly and he feels good that he didn’t wait!
However, the investment now starts to fall. As he watches, he remembers what an investment guru once told him about “buying” when everyone else is selling, so he does so.
However, the price continues to fall and George starts to panic. How has the price gotten that low? Surely it can’t go any further down?
It does. George now sells, thinking: “I’m out. Better try and salvage something from this mess.” The price continues to fall after he sold and George thinks: “Good thing I got out when I did!”
However, later the investment starts to climb slightly. George thinks: “No worries, it’ll dive again shortly.” When it does start to fall again, he feels vindicated.
However, when he comes back even later to check again, the investment has climbed back up even more. “How did this happen?” He cries.
As the price nears what it was when he bought before, he thinks: “It’s cheaper than it was the last time, let’s buy it again.”
And on and on the roller coaster goes. The point of this illustration is to show how powerful investment biases can be.
A solid investment strategy should not make decisions based on the pain or worry of short term loss. Rather, it should be constructed in a way which mitigates short term losses, and encourages growth and returns over a longer period of time.
So what kind of emotions and mental states can influence our investment decisions? Let’s look at this in a bit more depth below.
Recognising Our Biases
As financial advisers, we come across all kinds of investment personality types. Investment biases are numerous and can affect these different people in various ways, to varying degrees:
- Worry. A very natural and powerful human emotion, but some are more prone to anxiety triggers than others. People who worry a lot will often focus on the immediate risk element of investment opportunities, rather than the longer term potential rewards.
- Hindsight. Sometimes, we look at events in the past and believe that, at the time, those events could have been easily anticipated. In fact, it was not obvious at all to anyone.
- Avoiding Regret. Many of us make decisions because we want to avoid the regret that comes after making a choice which produces a negative result. The priority is therefore the aversion of pain, and it leads us to avoid sensible and balanced risks.
- Chasing Trends. Often, people will look at the historic performance of a particular investment opportunity, and believe this predicts how it will perform in the future. However, in reality the picture is more complex than this.
What To Do About It
Of course, as financial advisers in Nottingham, we are bound to recommend that you always seek professional, regulated and independent advice from a qualified financial planner before embarking on an investment plan.
Although we do not have access to a crystal ball, we can help you extract the disruptive emotion from your financial decision-making and avoid biases which can lead to costly mistakes.
Two particular areas where we can help include:
- Expert profiling, to help you more fully understand your attitude, tolerance and capacity to risk.
Portfolio construction and review, to help you diversify your investment plan appropriately in line with your circumstances, agreed risk profile and financial goals
In our next article, we’re going to talk about some practical things you can do to mitigate against investment bias.