Psychological traps when making investment decisions and how to avoid them
Research into behavioural finance has arrived at the conclusion that investors are only partially able to act rationally. Frequently when making investment decisions they are prone to various errors and distortions of judgement.
We have summarised the most widespread problems for you. Prior to making an investment decision, make yourself aware of these problems to at least mitigate severe errors of judgement, or in the ideal case, to avoid them altogether.
This describes the fact that the subjective value of a profit is often valued lower than an objectively equally high loss. Investors experience losses far more intensely than comparable profits. Consequently, investors focus more intensely on avoiding losses than seizing opportunities for profits. Frequently, securities that have performed well are therefore sold first, rather than those securities that have returned losses to date. Simply looking at the purchase price is not particularly helpful for making a decision. You should consider instead whether you would buy at the current price. It is also helpful to keep an eye on the overall performance of the portfolio. And: in a well-diversified portfolio there will always be individual positions, that perform less well. A stop-loss order might help you to limit your losses by setting a cut-off price at which a position should be sold why you purchase it. If the price fails to the stop price that has been set, then an order will be automatically transmitted and the position closed out at the next executable price.
Investors do not make rational decisions under prevailing mass psychological conditions, but instead frequently mimic the behaviour of the majority. Especially in uncertain situations, in particular ones triggered by shocks in financial markets, the number of people guided by facts frequently falls. In market events, herd behaviour manifests itself in the fact that strong price and exchange rate fluctuations occur due to homogeneous behaviour, as market participants, for example, increasingly invest in or sell an investment opportunity in clusters. You should critically question why you currently have a preference for a particular investment and why other investments appear unattractive. Becoming aware of such influencing variables may lead to better investment.
Investors like to base their investment decisions on readily available information that is current and easy to remember. Investors therefore consider future scenarios based on information that is easier to remember as being more likely than future scenarios that are more difficult to imagine. Availability heuristics entail an underestimation of risks that are currently undetectable or have not occurred for some time. As a general rule, in the capital market the availability heuristic leads to a reinforcement of the current view of the market. You should therefore be careful not to overestimate the current development in the environment of a desired investment, but to consider the long-term perspective, taking into account a broad basis of information.
People tend to afford a greater significance to more recent information than to older information. One explanation for the recency effect is that the short-term memory only has limited capacities and information that is not repeated is usually not transferred into the long-term memory. However, in the case there is no other subsequent information, then the most recent information remains in the short-term memory. To exist this recency effect, some advisers highlight the advantages of an investment at both the beginning and end, and mention the risks during the middle part of the advisory meeting, to disguise them. Try to examine all available information objectively comparatively against one another. Also be aware of the risks of an investment that the adviser does not highlight.
Home bias means that investors tend to have a preference towards investments in their home market. Reasons stated include high international transaction costs, a shortfall in the level of information, or the avoidance of exchange rate risks by investing in the same currency area. By doing so, the fact that investments are correlated more with another than investments that are internationally diversified, is frequently overlooked. As an investor, consider whether appropriate international diversification may decrease the risk of your investment and may improve the return.
Halo effects describe phenomena where the overall impression or a strongly pronounced feature affects the perception of other attributes of an item, and outshines them. As an investor, check the source of an investment idea for the blinding effect of such a halo effect. In the event of an investment recommendation being associated with positive attributions, ensure that you also check negative information.