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Making Rational Investment Decisions

buyCan people become rational investors? Or is there something we do that prevents us from consistently making sophisticated financial decisions?

Human motives and fears are now being recognized as an inherent part of investor behavior. How people invest, what stocks or funds they select, and their attraction to risky investments are among the factors being examined to determine the path investors take between objectively evaluating financial advice and succumbing to psychological traps that cause financial losses.

Today, the area of study known as behavioral finance has identified some key tendencies that can affect rational decision-making by otherwise thoughtful individuals and can mar the process through bias, overconfidence, and unchecked emotions. These tendencies can reduce the chances of making profitable investing decisions.

Behavioral finance gaining recognition

Behavioral finance moved to the international forefront of economic study when the 2002 Nobel Prize was awarded to Daniel Kahneman, a psychologist, and Vernon Smith, an experiment economist, for their work in developing tools to study individual investor behavior. This recognition prompted additional study of behavior patterns that people use when making investment decisions.

Psychologists are now using behavioral finance to solve some financial puzzles, such as why markets become grossly overpriced, or why sophisticated investors make very bad decisions.

According to Hersh Shefrin, professor of finance at the Leavey School of Business at Santa Clara University, there are some basic human behaviors that affect investment decision-making. Individual investors commonly think they make good decisions because they have good judgment and are objective. But there is more at work under the surface.

At the individual level, the driving factors are framing, overconfidence, confirmation bias, and the illusion of control. Here are the definitions of these key concepts:

Framing. When individuals make investment decisions, emotion and reason work together, but they produce very different emotional results depending on whether the investment made or lost money.

For example, according to Shefrin, people tend to feel the pain of losses much more strongly than the pleasure they receive from comparable gains. This emotional strain is magnified when the person assumes responsibility for the loss, and the guilt then produces an aversion to risk. But the level of guilt can vary depending on how a financial decision is framed. For example, if an investor lost money buying a stock, the person could justify the loss by saying the stock also paid a dividend.

Confirmation bias.This describes the tendency of people to favor information that confirms their beliefs or hypotheses. People express this bias when they selectively gather or remember information. Alternately, an investor can interpret information in a biased way. The bias is more pronounced with emotionally charged issues and for deeply entrenched beliefs. Confirmation bias is also exhibited when people interpret ambiguous evidence as supporting their existing position.

Illusion of control.This is the bias that develops when people overestimate their ability to control events. People can feel that they are able control outcomes that, in fact, they could never possibly influence. For example, a gambler or an investor who experiences a positive outcome may take credit for the outcome even though the event was largely determined by chance.

Making smarter decisions.These biases unconsciously drive investment decisions. For instance, a person may have reviewed the data and past performance of a stock, and then at a cocktail party he overhears another person talking about buying that same stock. That casual encounter can trigger a buying decision (confirmation bias) even though the decision had little to do with the facts about the company. Similarly, investors are notoriously slow to sell a poorly performing stock because they would have to actualize the losses and, more important, admit they made a mistake by holding it too long (framing).

Shefrin thinks that investors should become more aware of their own prejudices and preconceived views. They should recognize their own confirmation bias and not overlook evidence that may challenge their thinking. Effective investors should take the time to evaluate and even solicit opposing ideas.

While behavioral finance can help explain instances of “irrational exuberance” at the individual and group levels, its main benefit is to help identify how psychology affects financial decision-making. The challenge for investors is to recognize the psychological traps they use when making investment decisions.

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