In 2002, a psychologist won the Nobel Prize in Economics. Daniel Kahneman's award-winning work showed how our behaviour affects our investment decisions.
Kahneman argues that investment decisions are based on instincts and not information. And that these behaviour patterns are predictable. Kahneman identified some behavioural heuristics (or mental shortcuts) that affluent investors take, which may lead to wrong investment decisions. Here are some of them:
Overconfidence: Most affluent investors tend to 'over-rely' on their own judgment. Even if they work with a financial advisor, they expect the expert to produce higher-than-market returns. Good investors should look for long-term, consistent returns, and not the latest hot stock in the market.
Representativeness: The rich investors often attempt to predict the future from the past. To expect a stock to rise today because it rose yesterday is like saying it will rain today because it rained yesterday. And yet, many people make judgments based solely on recent returns.
Availability bias: To judge the likelihood of an event, investors tend to search their memory resulting in biased estimates. For instance, if asked to think of an English word with the letter 'k' in it, most choose a word beginning with 'k' whereas there are three times as many words with 'k' as the third letter -- make, like. So, immediacy scores. Investors tend to go by what they read about a stock in newspapers rather than evaluate its fundamentals.
Contagious enthusiasm: Affluent investors are prone to 'following the crowd.' During the tech bubble of the 1990s more the excitement, more was the investment until finally everyone realised that they were over-paying for the opportunities. If you hear about a hot new investment at a cocktail party, chances are the value has already been reflected in the market. Herd mentality will have you chasing returns instead of accomplishing goals.
Avoiding loss: Affluent investors are not averse to risks; they are averse to losses. Try this. You can either (a) win $80,000, or (b) have an 80 per cent chance of winning $100,000 (in other words, a 20 per cent chance of winning nothing). Now choose between (a) losing $80,000, and (b) an 80 per cent chance of losing $100,000 (conversely, a 20 per cent chance of losing nothing).
Kahneman found that most people chose (a) in the first part and (b) in the second. Even though the two situations had the same probability, people chose to avoid a loss rather than win more.
The way a decision is framed affects the outcome. To decide on a risky investment, you have to think in terms of personal outcome.
If you are right, you will make a handsome profit; if you are wrong, you will have to work three more years until retirement. Now, do you want to make the investment?
In my wealth management practice in the United States, we interview our clients on their needs, goals and objectives. Investing without a framework will ultimately distract you from what you want to accomplish and may also expose you to undue risk.
If you want to have money available for your daughter's wedding in two years, you may not look at a long-term investment. But, if you were saving for retirement in 25 years, a short-term fixed-income vehicle that doesn't keep up with inflation, may not be suitable.
What is important is how much risk you need to take rather than how much risk you want to take. Investors should know if the risk is appropriate to the return they expect. Using these tools you can manage your expectations and attitude towards investing. They help to understand your behaviour, know what you want to accomplish, and distinguish what decisions may distract you from your goals.
The author is president, Evensky, Brown, Katz & Levitt. Reach Katz at letters@outlookmoney.com