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Investor Psychology: Why We Fail to Make Good Financial Decisions

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Investors make better decisions when they separate emotions from the thought process, but it’s practically impossible to achieve the goal in perfection. Regardless of how hard one tries, emotions will always be present. The best an investor, or anyone who makes decisions about finances, can achieve is awareness of the ways psychology prevents optimal decision making.

I took Kiplinger’s new investor psychology quiz, which focuses on the ways investors’ brains work against us as we try to make solid investment decisions. I answered seven of the eight questions correctly. The quiz was a good reminder of the brain’s subtle ways of changing perception and understanding of a situation.

Here are some interesting aspects of psychology that hinder the best decision-making.

Recency effect

We tend to remember better events that happened most recently. While at the peak of a bubble, like we’ve seen in real estate and stocks, several years of increases hide the reality that bubbles burst when high prices are not supported with fundamental value. Likewise, if you are asked to review your experiences at a restaurant, even if you have visit that restaurant for decades, your most recent experience at that venue will have the most weight.

Here’s how this can damage you: In the midst of a recession, it seems like the stock market keeps getting lower. All we see is bad news like financial scandals and corruption. We forget that over the long term, the stock market has been the best way to grow your money. So we abandon the stock market and miss out on those gains when the economy rebounds.

Confirmation bias

There are certain things we want to believe. Several years ago, a friend told me that “real estate always goes up.” There’s the recency effect again. Also, to believe that any investment can’t fail, we must ignore information that does not fit in with that philosophy. We seek out the studies or opinions that match our own as we look for confirmation.

Here’s how this can damage you: If you are looking to buy a house, it would be smart to look for reasons that the purchase will be financially sound over the long term. You will cite the usual positive aspects of home purchasing, including the fact that it’s an asset likely to appreciate and you receive a small tax break on mortgage interest, but you’ll likely ignore the fact that you’re likely to move out of the house before buying gains its advantage over renting.

Losing money is painful

The brain reacts to losing money the same way it reacts to pain. As pain is something we are built to avoid, we also try to avoid any potential for losing money. On the surface, this sounds like it would be a good thing, producing decisions that are more likely to side with gaining rather than losing. What really happens is that if we are presented with a situation where we have an even chance of winning $150 or losing $100, we won’t take the chance.

Here’s how this can damage you: The fear of losing money and experiencing the associated pain will keep us from taking risks. For people invested in the stock market, the pain experienced when reading those quarterly statements with negative returns causes many to sell at the wrong moment. They’ll miss out on the market’s rebound. While the stock market has a great track record over long periods of time, if you’re only invested when the market is decreasing, your performance will never match the stock market.

Want more? Here’s a list of cognitive biases. Just about everything pertains to financial decisions in some manner.

Photo credit: Martin Pettitt

Updated January 16, 2010 and originally published October 21, 2009. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Luke Landes is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about Luke Landes and follow him on Twitter. View all articles by .

{ 6 comments… read them below or add one }

avatar ctreit

There are a bunch of other psychological tricks our brains plays on us. You can read up on this stuff by searching for “Richard Thaler” on amazon. There you will find a few books from an academic who started work on behavioral finance early on, but these books are easy enough to understand so that the average person can also get the idea. I also found a book by Kahneman and Tversky on the first page of my search for Thaler. Kahneman got the Nobel price for his work in behavioral finance. (Tversky was dead when the prize was awarded.) – Now here is the tough part. Even if you know about these psychological failings (like I do), you still make mistakes (like I do).

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avatar Neal@wealthpilgrim

This is really critical to discuss and to continue discussing.

Thanks.

What I find intriguing is that even though we KNOW we do this, we tell ourselves, “this time it’s different” and then we end up shooting ourselves in the foot…..

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avatar Aaron Caldwell

What a great blog post. Heavens knows we all get caught up in the psychological aspects of trading and are worse off because of it. I know I am guilty of being out of the market for this great run up after the precipitous fall. Missing out on this has been painful.

I’m wondering how one becomes a member of your blogroll?

Thanks!

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avatar Austin

I only started investing a little over a year ago and I was amazed at how psychological it was.

I bought some individual stocks with some excess money after the economy went south because I wanted to test myself and see what it was like to own individual stocks and to deal with the day-to-day changes.

It was a great learning experience, but I quickly learned that day trading and watching CNBC all day was not my idea of a good time.

Great article, Flexo.

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avatar Save Money Hound

Very insightful. I think sometimes we only want to see what we want to see. Emotions often cloud judgement and even though we know that it is affecting our financial decision making somehow it seems to have a greater pull on us than making a decision based on logic and reasoning. Heart over mind i guess.

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avatar Greg Retzloff

Belsky and Gilovich’s “Why Smart People Make Big Money Mistakes.” is a very readable and practical introduction to behavioral finance. It references the work of Thaler, Kahneman and Tversky (mentioned above by ctreit) and explains the implications of their work for the general reader. The book also offers a valuable “what you can do about it” section at the end of each chapter.
And Aaron, my brother, you are guilty of nothing other than believing that market timing is a viable investment strategy. Belsky and Gilovich wrote their book for you. Good luck!

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