Why do smart people make bad financial decisions ?

The research behind behavorial finance is expanding exponentially, uncovering more gaps in our collective knowledge of how financial markets actually work. Here are some of the most common mistakes...

Traps to avoid with our investments

Both traditional finance and basic economics assume all investors behave rationally at all times. All investors can access the same information and all act in their best interests. Behavioural finance theorists believe it's more complicated than that.

I have described below the six most dangerous attitudes we encounter most frequently in the financial markets :

1 – Anchoring : "The strong inclination investors have to latch on to a belief, a data point, or a prior experience".

Example : An investor who may be reluctant to buy more of an investment because it was cheaper last year.

Impact : "Anchoring" on meaningless numbers or on historical performance can be dangerous and can lead an investor to avoid opportunities. Almost all the stocks are more expansive now than they towards the end of 2008 !

2 – Framing : "Investors' opinions and decisions depend largely on how a situation or choice is presented."

Example : An investor who prefers to invest in companies of his own country, province, or his employer.

Impact : If the investor cannot take a step back to view what's beyond the frame (to see the forest through the trees), there is a risk of missing opportunities. There is also the possibility of taking to much risk by failing to diversify geographically, or by having a strong concentration in a sector or a company.

3 – Loss aversion : "Exhibilitng greater anxiety on a loss than pleasure from a gain, regardless of the scale".

Example : An investor who tends to hold onto stocks long after a loss in hopes that the investment will break even.

Impact : The investor may ignore the fundamentals and irrationally continue to hold a stock in hopes of avoiding the pain of a realized loss. A lot of investors have gone through this with Nortel.

4 – Overconfidence : "Occurs when investors overestimate their abilities to choose a good investment or make correct decisions".

Example : An investor who is convinced that a particular investment will have a large pay off.

Impact : Straying beyond their circle of competence. Also, the investor who is "certain" of making a lot of money might overlook the risks attached to the investment in question.

5 – Ambiguity aversion : "The attitude or preference for known risks over unknown risks".

Example : An investor who has been driven to cash and is waiting for the markets to recover before investing.

Impact : Investors sometimes miss opportunities because they are waiting for known events to appear.

6 – Regret avoidance : "Avoiding the possible regret of making a wrong decision (choosing a losing investment or not choosing a winning investment)".

Example : An investor who does not act for fear of making a mistake.

Impact : Here, the investor may want to avoir the regret of making the wrong decision and is led to investment paralysis.

I hope you have enjoyed my article. Do not hestitae to contact me if you have any questions on this matter.

Cathy Duval, CFA

Source : Flyer from Invesco Trimark ; Investor behaviours.