Why Investors Make Bad Choices

Fear or Guts?

I took this from the On-Line Star so that any one dabbling in stocks will learn how not to make bad choices.

"Investments are a very serious matter. As with other important aspects of our lives, proper decision-making is integral when it comes to investing. While not every investment decision we make can be 100% accurate, we do possess the necessary prudence to differentiate what a smart choice is from a less ideal choice.

So, despite having the aforementioned prudence, why do we still make ill-advised choices in terms of investments? There are three factors that affect our choices, as these are closely in line with our behaviour.

 Availability bias

According to behavioural scientists, availability bias is a person’s tendency to assume that if a certain incident has happened before, then that incident happens to be “available” or can and will happen again in the future.

The problem is that people also have a tendency to exaggerate on the probability that those events deemed available will happen again.

In terms of investments, availability bias works both ways. For one, investors who have enjoyed a measure of success in a particular investment in the past will have a particular prediction to the same type of investment, even if the results strongly advise against further investments. 

By the same token, people who have experienced some form of failure in specific investments will tend to exaggerate the frequency with which such instances do occur, thus clouding their decisions.

Loss aversion

Loss aversion is something that affects investors for the simple fact that nobody likes suffering loss of any kind. In fact, it is theorised that the level of impact loss has on a person is greater than the impact of a gain. This means people will not generally mind not gaining anything, as long as they do not suffer any loss. 

From an investment point of view, losses tend to come with the territory. However, it is hard to bounce back from loss, even for seasoned investors. 

A loss, especially a significant one, naturally affects choices investors will subsequently make; essentially preventing them from taking risks that may possibly yield high returns because the negative feelings—the disappointment, frustration, pain and even, to an extent, humiliation—associated with the loss are all too much to go through again. 

While many will argue that a person tends to harden after several losses, behavioural theorists claim that loss aversion operates mostly on a subconscious level. Most of us even avoid loss without even knowing we are doing it. 

Probability neglect     

Probability neglect revolves around how people tend to become emotional during high-pressure situations or any scenario wherein there is a weighty consequence to every course of action. 

Basically, this means that people get emotionally rattled, so much so that the focus will remain on the worst-case scenario of any situation instead of logically analysing probable scenarios and looking at the situation with a level head. 

When it comes to investments, a level head can mean the difference between a smart call and a poor choice. Probability neglect prevents an investor from looking at all the available pieces of information regarding a particular investment—seeing, instead, only the pieces of evidence that reinforces the perceived worst-case scenario. 

One solid example of this is the investing attitudes in the market after the recession. After the crash, investors were more reserved in their investing, due not just to probability neglect, but to a combination of all three factors specified here. The huge losses a lot of investors suffered have had most of them second guessing all the investment choices they have made. 

After all, if they were wrong once, the possibility remains that they can be wrong again. They have suffered losses they do not wish to suffer through again. And, a lot of them have become focused on the potential of another crash that an objective and logical decision becomes harder to make. 

This whole scenario shows that investors, despite all their power, resources and savvy, are also subject to the same kinds of pressures everyday Malaysians face. These factors are all normal human behaviour.

The difference between successful investors and failed ones, however, is not just making consistently right choices, but also knowing how to anticipate and appropriately deal with losses as they come.   

This content is created by Nazirah Ashari for the readers of The Star. Nazirah is Head of Content at CompareHero, the leading Malaysian financial comparison platform, aimed at helping Malaysians save time and money. "