How ‘Good’ Ideas Sometimes Lead to Bad Investments

Mental shortcuts for decision-making sometimes trip us when analysis is warranted.

Policy statements, plans and strategies can help keep investors on target.

Many-do it-yourself investors wonder why they often end up buying high and selling low. It’s probably not for lack of intelligence. Bad judgments can arise if investors are not introspective about their real motivations for selecting a time to buy or sell, or any specific investment.

Psychologists have identified a number of common biases guiding the investment decisions of less experienced investors.   If you are wondering whether the latest crisis in world events should guide a specific buy or sell decision, take a look at this list and reflect first what other motivations may be prompting you.

Reasoned investing usually does best within the framework of a plan or investment policy statement. Then the investor can calibrate individual choices to fit with the overall strategy and timeline for accomplishing specific goals. Need help? I am happy to talk.

Most Common Behavioral Biases in Investors

Ambiguity AversionDislike of ambiguity, masked as risk aversion, drives decisions.
Anchoring and AdjustmentLatching on to a specific price and make subsequent investing decisions based on that, for example, “I will sell (or buy) abc stock when it reaches a certain price.â€
AvailabilityEstimating the probability of an outcome based on how prevalent or familiar that outcome appears in their own lives.
Cognitive DissonanceThis happens when newly-acquired information conflicts with a person’s understanding or beliefs. Investors with this tendency often go to great lengths to rationalize their investment decisions.
ConfirmationHolding perceptions and emphasize ideas that confirm their beliefs, while devaluing information that contradicts their beliefs.
ConservatismClinging to prior views of forecasts and resists new information.
EndowmentEndowing assets that one owns with higher value and sets a higher minimum selling price for those assets than what one would be willing to pay for the same or corresponding assets.
FramingResponding to various situations differently based on the context in which the choice is presented or framed.
HindsightPerceiving an event to have been predictable, even if it was not.
Illusion of ControlBelieving  one can control or at least influence outcomes when, in fact, one cannot.
Mental AccountingTendency to evaluate economic outcomes based on the origin of the money (e.g., work, inheritance, bonus, etc.) rather than on a holistic view of the assets.
OptimismOverly optimistic about the markets, the economy and the potential for positive performance of their investments.
OverconfidenceAn unwarranted faith in one’s intuitive reasoning, judgments and cognitive reasoning as well as an overestimation of their own predictive abilities and the precision of the information on which they base their decisions.
RecencyRecalling and emphasizing recent events and observations more prominently than those that occurred in the near or distant past.
Regret AversionAvoiding decisive action because of the fear that whatever course is taken will prove less than optimal.
RepresentativenessPerceiving probabilities and odds that reinforce their own pre-existing ideas even when they are statistically invalid.
Self-AttributionCrediting one’s successes to one’s own talent or foresight, while blaming failures on outside influences, such as bad luck.
Self-ControlThe human tendency to consume today at the expense of saving for tomorrow.
Status QuoPredisposition to elect whatever option ratifies or extends the existing condition.

With Credit to: D. Hirschleifer, 2001, Investor Psychology and Asset Pricing, Journal of Finance, V. 56.

*Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Posted in