Mental Quirks that Lead to Bad Decisions

The human brain is amazingly complex, flexible and able to process a vast amount of information. Even today’s supercomputers are not up to the task as far as raw processing power. The human brain has them beat…at least for the moment. But past these amazing stats and processing power, the human brain is also subject to some very real, emotional, limitations. We haven’t yet evolved that much past cavemen despite our technological advancement.

Researchers are discovering that certain mental quirks often lead us to make poor financial decisions – errors that can damage our long-term investment portfolios. This field of study is called “Behavioral Finance” and looks at how psychology influences the investment choices we make.

Why is this important? Well traditional financial theory holds that all investors are purely rational creatures, not subject to emotions. And that the market is “efficient”, one in which prices completely and accurately reflect all information such as economic reports that could possible influence the value of stocks and bonds. However, the reality, as most of us know, is far from this.

The financial crisis of 2008-2009 is a great example of what I’m talking about. Crazily, large numbers of investors ignored critical information both in bidding stocks up and them pounding them back down. Remember the dot-com bust of the 1990’s? There are examples of “irrational” behavior going all the way back to the 1720’s, England’s South Sea bubble.

Behavioral Finance tries to explain why this happens. It’s not that we’re all irrational, it’s just that our thinking is often guided, or misguided, by subtle biases and mental blind spots. These “cognitive illusions” include:

• Overconfidence-Assuming you know more than you do or that your past decisions have been good ones. This can lead to aggressive trading behavior.
• Mental Accounting-Rather than rationally viewing every dollar as identical, many investors designate some of their dollars as "safety" capital which they invest in low-risk investments, while at the same time treating their "risk capital" quite differently.
• Anchoring-Fixating on past prices, such as how much you paid for a stock. That’s why some investors refuse to sell at a loss, even if they could move their money to securities that have higher expected returns.
• Loss AversionPeople feel the losses more than they feel gains. So, even though selling something at a loss can be the best decision, it may not happen.
• Framing-Reacting to choices depending on how they are presented. Would you rather have 100% chance at $1,000 or a 2% chance at $50,000? These are identical questions….

I hope this has helped in trying to explain some of the craziness that happens in the financial markets. But understanding how these biases can cause dangerous errors is only the first step. The next step is recognizing your own strengths and weaknesses. Ever made a financial decision you regretted? I know I have.