The subconscious biases putting your investments at risk - Part 1
Welcome to our series on the dangers of human bias in investing.
We’re all guilty of it. We often make decisions in the heat of the moment, reacting emotionally to isolated news without seeing the whole picture first. And that’s just in our day to day lives.
What about when it comes to something as important as our financial futures?
Sadly, the bias is still there, now amplified by the monetary impact each decision can make.
While a good psychologist would likely be able to break down these thought processes into thousands of categories and rationales, we decided to simplify it down to just four main categories.
In part 1 of this series, we’ll be tackling Loss Aversion.
What’s loss aversion?
In 1979 (and further developed in 1992), trailblazing psychologists Daniel Kahneman and Amos Tversky developed something called Prospect Theory, which eventually won the Nobel Memorial Prize for Economics in 2002 - so it’s pretty smart.
They theorised (courtesy of Investopedia) that…..deep breath…..prospect theory belongs to the behavioural economic subgroup, describing how individuals make a choice between probabilistic alternatives where risk is involved and the probability of different outcomes is unknown. 😳
In normal people language please?
They took a long look at us and built a modern understanding around why no one likes that losing feeling. In short, their research showed that the pain of loss is about twice as great as the pleasure of a comparable gain.
Broken down, this means that you’re more likely to choose a sure gain over a riskier possibility, even if it’s a possibility of gaining a larger reward. And this even proved the case if the result would turn out equal, but the presentation of the offers made one guaranteed and the other appear less so.
We then treat losses in the opposite manner. When presented with a sure loss and the risky possibility of a larger loss, we become willing to take more risk in an effort to reduce / remove the loss, as opposed to taking the smaller guaranteed loss. Again, this proved the case even if the result would turn out equal, but the presentation of the offers made one appear the sure thing and the other a possibility.
The fear of failure can lead us to become overly risk averse and inactive at times when we could possibly gain more, and then risk seeking at times when we could possibly lose more.
It’s really quite interesting stuff, and shows just how odd our psychological makeup can be.
What else should we watch out for?
Our next entries in the series will cover the dangers of Hindsight, Herding and Familiarity. So stay tuned.
As a reminder, these are just four of the many issues that are clear in human decision making.
But don’t panic. There’s one thing that makes us (at Exo) feel better - data doesn’t get emotional.
Well, except for that one time Lt. Commander Data cried after finding his cat. Any Trekkies out there???
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