From making decisions to investments, you may be at the mercy of your mind’s strange workings. Financial decisions are among the most important life-shaping decisions that people make. We review facts about financial decisions and what cognitive and neural processes influence them. Owing to our cognitive constraints and a low average level of financial literacy, many financial decisions people make violate sound financial principles.
Households typically have under- diversified stock holdings and low retirement savings rates. Investors over extrapolate from past returns and trade too often. Even top corporate managers, who are typically highly educated, make decisions that are sometimes driven by overconfidence. Many of these behaviors can be explained by well-known principles from cognitive science.
A boom in high-quality accumulated evidence–especially how practical, low-cost nudges can improve financial decisions, is already giving clear guidance for balanced government regulation.
There is an inherent tendency in people to stick to their own notions and ways of thinking and thus avoiding change in their decisions.
There is the so-called anchoring trap, which refers to an over-reliance on what one originally thinks, meaning the mind gives disproportionate weight to the first information it receives. Initial impressions, estimates or data anchor subsequent thoughts and judgments. Imagine betting on a football match and choosing the team purely based on who has kept the most possession in their last five games. You may come out all right by picking the statistically more controlling team, but the team with the least possession may specialize in counter-attacks and just need those few chances where they have a high conversion rate. Clearly, any metric can become meaningless when taken out of context.
In business, a common anchor is a past event or trend. While relying on such may lead to a reasonably accurate estimate of future numbers, it also tends to give too much weight to past events and not enough to other factors. Especially in markets with rapid changes, historical anchors can lead to poor forecasts and misguided choices. Take, for example, Blockbuster. Once a provider video game rental services through video rental shops, DVD-by-mail and video on demand services, the chain was crushed by online OTT platforms such as Netflix. Those trapped in the perception that Blockbuster was there to stay, lost tons of money as the company filed for bankruptcy and ultimately shut down.
Very similar to this is the irrational exuberance trap where investors start believing that the past equals to the future and they act as if there is no uncertainty in the market. Unfortunately, uncertainty never vanishes.
Believing that the past predicts the future is a sign of overconfidence. When many investors are overconfident, we have the conditions of Greenspan's famous, irrational exuberance where investor overconfidence pumps the market up to the point where a huge correction is inevitable. The investors who get hit the hardest — the ones who are still all-in just before the correction are the overconfident ones who are sure that the bull run will last forever. Trusting that a bull won't turn on you is a sure way to get yourself gored.
Even after investors start losing money they find it difficult to change their decision. This is the sunk cost trap which is about psychologically (but not in reality) protecting your previous choices or decisions — which is often disastrous for your investments. This occurs when we’re unwilling to admit a mistake and pull out of it timely. Acknowledging a poor business decision is a very public matter, inviting criticism from colleagues and bosses. It’s psychologically safer to justify past decisions, make allowances and continue a tenuous course even when we know the outcome is risky.
It is truly hard to take a loss and/or accept that you made the wrong choices or allowed someone else to make them for you. But if your investment is no good or sinking fast, the sooner you get out of it and into something more promising, the better. If you clung to stocks that you bought in 1999 at the height of the dot.com boom, you would have had to wait a decade to break even, and that is for non-technology stocks. It's far better not to cling to the sunk cost and to get into other assets classes that are moving up fast. Emotional commitment to bad investments just makes things worse. In order to avoid this trap, you need to remain flexible in your thinking and open to new sources of information, while understanding the reality that any company can be here today and gone tomorrow.
What can be even worse than the sunk cost trap is situational blindness. Even people who are not specifically seeking confirmation often just shut out the prevailing market realities in order to do nothing and postpone the evil day when the losses just have to be confronted. If you know deep down that there is a problem with your investments, such as a major scandal at the company or market warnings but you read everything online except for the financial headlines, then you are probably suffering from this blinder effect.
The bottom line is that human psychology is a dangerous thing and there are some alarmingly standard mistakes that people make repeatedly. It is very easy to fall prey to these mind traps. Misguided perceptions, self-delusion, frantically trying to avoid realizing losses, desperately seeking the comfort of other victims, shutting out reality and more can all cost you dearly.
Thus it’s imperative to be aware of the nature of these traps to be able to avoid them. A person who understands the human psyche in this respect will always be better equipped to avoid downturns while a person who knows the workings of the mind and can think straight could even profit out of it.
WRITTEN BY:
PARTH
댓글