Investor confidence, emotions and psychology play a powerful role in driving share markets. Past experiences, pre-conceived ideas and fear of regret are just a few of the biases and behaviours that can lead investors to make emotional and often irrational decisions.
Identifying and understanding these behaviours can help investors avoid many investment traps and lead to better investment outcomes.
Regret – afraid to make the wrong decision
The key underlying premise for this behaviour is an investor’s fear of incurring losses. This fear of making the wrong decision often means investors don’t assess risk correctly – they tend to over-emphasise risk which can actually lead to wrong decisions or inertia in making a decision. Investors need to ask themselves which risk is greater: the risk of making a decision that could lose them money; or the risk of missing out on an opportunity that could make them money? Studies have shown that people tend to have the highest level of regret for actions they didn’t take rather than actions they did take.1
An example of regret is an investor’s difficulty in selling a losing stock. The feeling of regret is strongest when the loss is crystallised – until that point the investor holds out hope of the stock returning to its ‘former glory’ and avoids generating feelings of regret by holding onto it. Another aspect to this is that if the investor made the original investment decision by themselves, the feeling of regret is much greater than if they were following someone’s advice. It’s not so much about the pain of making a loss, but rather the pain of being responsible for making the decision. This could explain why investors sometimes find it easier to outsource their investment decisions (ie to a financial adviser) – apart from needing professional advice, it also means some of the burden of making decisions is shared.
The fear of regret often leads to inertia in making decisions. In some respects this could be one of the reasons why around 80% of Australians have remained in the ‘default’ fund in their superannuation plan, despite encouragement from the heavily publicised ‘Super Choice’ campaigns. As the default option tends to be a balanced fund, this can mean a significantly lower superannuation payout on retirement than if invested in a higher growth option over an individual’s full working life. Not making a choice therefore potentially exposes investors to greater risk – they are swapping the risk of losing money with the risk of not having enough money in retirement. Given many super investors have a very long time horizon the latter risk is likely to be significantly higher than the former.
Emotion and the human psyche are indeed powerful forces, often leading investors to make irrational decisions, or sometimes even worse, not making any decisions – both of which can be detrimental to the long-term performance of an investor’s investment portfolio. By removing these emotions and psychological behaviours from the decision making process, investors are in a better position to make logical and rational decisions. Seeking professional investment advice from a financial adviser, taking a long-term view, constructing portfolios based on an investor’s risk/return profile and investing with professional fund managers are steps an investor can take to help them achieve this.
Source: Tyndall Investments
1 Source: Hersh Shefrin (2002) “Beyond Greed and Fear, Understanding Behavioral Finance and the Psychology of Investing”,
http://www.financialplanner-newcastle.com.au
http://www.self-managedsuperfund.com.au
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