Psychology explains irrational investing decisions

By Staff Reporter 06 June 2014 | 1 minute read

Investors should be wary of making poor decisions as a result of psychological biases, a behavioural analyst has warned.

People tend to be biased towards certain types of information and stories, even where these do not provide the most comprehensive understanding of the market, Behavioural Finance Australia director Simon Russell said.

“Study after study shows the psychological influences are real, and despite the feeling they don’t apply to us, their effects on our decisions, on our wealth and on market cycles can be substantial,” Mr Russell said.

Firstly, many investors are over-reliant on recent data at the expense of longer-term historical trends.

“International research shows that investors’ expectations of greater future returns tend to be higher in places where prices have run up the most in recent periods,” Mr Russell said.

Strong recent price growth may cause some investors to overlook the fact the market typically has flat periods as well, he warned.

Another pitfall is relying on personal experiences and memorable anecdotes from friends or acquaintances over hard data.

“Where we are affected by others, we tend to focus on highly salient individual stories rather than the much more representative statistics that may reflect the experiences of hundreds or thousands of people,” Mr Russell said.

“A fully rational investor should place more weight on the aggregated experiences of the many than the vivid stories of the few, but that’s not how our brains work.”

Mr Russell said these effects could be difficult to overcome but investors could try a number of tactics.

“These include enhanced learning and self-awareness, coaching and having a rigorous investment process,” he said.

“In addition, there are opportunities to benefit from market insights based on the psychological influences that affect other investors.”

Psychology explains irrational investing decisions
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