Why Do Investors Make Bad Decisions?

Examining the growing field of behavioral finance.
May 1, 2016
Julie Burenga
Why Do Investors Make Bad Decisions?

According to conventional financial theory, the world and its participants are, for the most part, rational “wealth maximizers.” However, in reality, there are many instances where emotion and psychology influence our decisions causing us to behave in unpredictable or irrational ways. Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.  

Many investing mistakes are caused by good old fear and greed. For example, investors have a greater reaction to losses than equivalent gains. If you suddenly lose $10,000, the distress you would feel would almost certainly be greater than the joy you would feel if you suddenly gained $10,000.

Another mistake commonly made is called “confirmation bias.” This means we have a preconceived notion about an investment or decision, and seek out information that supports our original belief, and ignore data that does not. For example, if you love your new iPhone and buy Apple stock because of it, regardless of price.

The tech bubble of the 1990s was a good example of “herd mentality” which is another behavioral driven investment mistake. Two factors contribute to herd mentality: 1) the need to conform; 2) the belief that a large group of people can’t possibly be wrong. 

Other emotional factors contribute to investment losses. Overconfidence in our investing ability leads to errors in choosing investments and deciding when to buy or sell. We also have a tendency to overreact to new information. This is especially volatile in today’s environment of immediate and constant news access. Behavioral economists also have found in their studies that investors are prone to “gambler’s fallacy.” In this instance, just as a gambler playing the slots believes that if they continue to play their odds of winning goes up, investors suffering gambler’s fallacy look at an investment and believe that its future performance is tied to what it has done most recently. 

Emotion and psychology affect every decision we make and investing is no different. One of the most valuable roles a professional financial advisor plays is helping a client to not fall prey to these behavioral miscues. Financial advisors help clients examine the reasons behind decisions, analyzing the fundamentals of investments and navigating the emotional factors. For individual investors working without an advisor, you should be aware of the tendencies to react emotionally and be sure to carefully review investment decisions to avoid making these mistakes.


About the Author

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Julie A. Burenga, CPA, CFP®
Jehl & Kreilach Financial Management
julie@jehlandkreilach.com 
(260) 420-0268 
jehlandkreilach.com

 


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