[Fin Talk] Psychological influences in investment decisions
Updated: Apr 28, 2021
By Arlyn Tan
Investment yield has always been a performance measurement indicator and a deciding factor in asset preferences. People are attracted to invest in assets which show historical positive returns. The common assets that Filipinos own range from real estate, businesses, equities, and bonds. Beyond the knowledge about the asset, investors rarely consider that investment wins are highly dependent on the awareness of their emotions and biases.
In your investing journey during the pandemic, did you have time to correlate the asset values with your emotions, perspectives, and behaviors? Your investment decisions can be further understood through behavioral science.
Behavioral finance is the science that studies the psychological & social influences on investment decisions. Appreciating this science allows you to accept that traditional financial theories are unable to explain why assets prices are too high for its real value. Understanding the three biases more than the financial theories can explain why you sold or bought assets, pre pandemic or during pandemic.
The fear of regret makes a person omit decision making. He finds validation in the decisions of the crowd. He is also happy to choose investments that have lesser returns as long as he is able to sleep well at night.
With your extra cash, did you purchase new assets in the real estate or the stock market because everyone is in that direction? Did you follow the crowd during the March 2020 sell off? Did you see any opportunities in investing in unpopular names which can grow significantly in the future?
Address the fear of regret by studying the effects of investing on an asset class in your portfolio, liquidity and happiness levels. Create a diversified portfolio in terms of asset type, sector mix, and geographical allocation. By investing both in known names and in unicorns in appropriate percentages can give you optimal returns.
The pain of losing something is more powerful than the joy of earning. The loss aversion causes irrational decisions like early profit booking. However, the truth is the investor may lose opportunities of earning more if he held on longer. In market selloffs, people avoid the pain of losing by cutting losses when the markets are going down sharply.
Did you choose the guaranteed products over the non-guaranteed products to avoid any kind of losses? Did you sell your winners because it gave you at least 10%?
A good example of this fallacy is when Baguio residents sold their properties at fire sale prices in 1991 after the July earthquake. Owners are fearful that properties will not recover their values.
By being aware of the loss aversion fallacy, you would be able to manage your emotions when the asset prices dip by 20%. You would be able to appreciate the beauty of combining guaranteed and non-guaranteed products. The awareness will push you to act based on logic and not emotions.
The endowment effect skews the investor’s perception of the value of an investment. As a seller, you price the asset lower while it is the other way around for owners. Because investors usually fall in love with their assets, they often hold on to an asset even if it is underperforming.
During the pandemic, there were businesses that needed to take a long pause. Newspapers published that Forest House and Shangri-la Restaurant had decided to permanently close operations. Despite its huge following, the owners had realized that dine-in, party places and tourist themed businesses are being hammered down in the pandemic.
Before checking your portfolio, take time to set your mind to be as objective as possible. Knowing that the endowment effect exists, you can let go of your losers with peace of mind. Giving up an asset to replace it with another is the best way to move on. A good example to follow are entrepreneurs who bravely decided to give up their pre pandemic cash cows and shift to activities that can give +10%-25% returns in the long run.
As an individual investor, did you find the reasons why you had superior returns in some assets and you wish you didn't need to deal with other losing assets ? Investing on your own has its rewards like the euphoric feeling when things are going right. On one hand, it can cost you sleepless nights because you feel alone & confused. When the heart is winning over your mind, engage the services of trusted financial professionals whose objectivity and track record are unquestionable.
Knowing thyself is an acknowledgement of the limits of our biases and beliefs in financial decisions. This is a process that we can continually pursue in our investment journey. From now on, turn the three biases into your best friends forever ( BFF) as you create far more superior investment strategies.
Arlyn Tan is a Strategic Wealth Consultant. She helps individuals and organizations on how to maximize the value of their money through risk, health & wealth management. Her mission lies in making sure that clients achieve 3 things. First, they reach their milestones on time with sufficient resources. Second, they protect them from the impact of economic losses secondary to unexpected events. The third and most important is that they enjoy meaningful and balanced lives.
LinkedIn/Twitter: Arlyn Tan