Wednesday, October 5, 2011

Emotions Hinder Good Decision Making

You think you can outsmart everyone else, you believe in exciting investment stories, you trust your investment decisions to be logical. How do we know? We’re humans too.

Besides fundamentals (e.g., earnings growth and valuations), stock markets are driven by investors’ emotions. Their emotions pervade all manner of good and bad financial news, enveloping market performance in messy layers of ‘noise’. As a result, good news doesn’t necessarily mean positive performance, and bad news doesn’t necessarily mean negative performance.

Alas, a self-respecting investor will not admit that he can’t see beyond his arm’s reach in such situations.

The Seven Sins

James Montier, the author of Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance, summarised common human biases into the “Seven Sins” of money management:
  1. Evidence shows that investors are bad at forecasting, even though it could be an integral part of their investment process;
  2. Investors cannot seem to have enough information, even though more information might not lead to better investment decisions;
  3. Investors overrate meetings with management because management themselves are probably biased;
  4. Investors think they can outsmart everyone else;
  5. Investors tend towards having a short-term horizon;
  6. Investors ignore the boring facts in favour of new and exciting stories, which are further enhanced to suit investors’ biases;
  7. Investors tend to believe, rather than be naturally skeptical.

Hardwired For Poor Decision Making

Montier also stated that in decision making the brain defaults naturally to an “emotional system”. People tend to focus on short-term gratification, leading to quick and easy decisions. Also, people tend to dislike social exclusion behaviour, preferring to follow the herd instead. This emotional system, he claims, exerts less energy compared to objective thinking.

Despite our beliefs that we are logical and rational decision makers, we are hardwired for poor decision making.

Is There A Way Out Of Behavioural Pitfalls When Investing?

Yes, and one such way out is the Dollar Cost Averaging (DCA) method. It is a method that sticks to a strict investment schedule regardless of how the markets are performing. It is very mechanical and there are no emotions involved. 

In Conclusion

Having emotions per se isn’t a bad thing but not many people can remain calm and collected when the stakes are high in decision making. However, recognising that emotions are an innate weakness when it comes to decision making is as good as taking the first step towards successful investing.

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