Whoever is free of errors, better not make investment decisions

Among the multiple decisions that a person must make, it is presumed that investment decisions are one of those that should be more “rational”. This belief may be supported by different factors: their relevance, considering they have a strong impact on future well-being; and because they are decisions about “money”, which seems to make them more quantifiable and structured.

When it comes to the financial decisions of a company, this assumption of rationality is imposed with greater force, since it assumes there are methodologies and processes to adopt these decisions. Surely, we can quickly agree that they “should” be rational, but beyond our claim or requirement, it is worth asking the following question: are investment decisions always rational?

For several years, different areas such as Behavioral Economics, Neurosciences and Decision Theory have been studying how real people usually make decisions in real situations. Numerous discoveries have been made about some systematic errors that we make when deciding and from which investment decisions are not exempt. The way in which our brain works, involving emotion and always tending towards stability and simplicity, sometimes makes us fall into traps that researchers have called cognitive biases. Let’s briefly review only some of the most representative ones.

I trust my estimates (sometimes, too much)

Investors often assume they know more than they really do. Despite continually estimating forecasts on uncertain variables (for example, the price of the dollar in the next year), the ranges of possible future values on which they base their investments are usually too narrow, falling into an “overconfidence” that later leads to surprises that are sometimes not entirely pleasant.

One of the main characteristics of overconfident investors is that they tend to trade stocks more frequently than other investors because they believe their skills will allow them to beat the market. However, in a study that analyzed the individual accounts of several tens of thousands of individual investors, O’Dean and Barber (1998) found that the top 20% of investors who traded the most between 1991 and 1996 earned an annual return of 6.6%, while the rest of the investors in the sample achieved an average of 17.7% per year.

If I don’t make changes, I don’t regret it so much

Mr. Carlos owns shares in company A. During the last year he considered the possibility of exchanging them for shares of company B, but finally gave up on his idea.

Now, he discovers he would have done better (+$20,000) had he switched to company B. Mr. Jorge had shares of company B. Last year he decided to switch to shares of company A. Now, he discovers if he had not switched, he would have gotten better results (+$20,000). Who feels worse? Almost everyone agrees that Mr. Jorge probably feels worse than Mr. Carlos, although in financial terms the results are the same (both could have earned +$20,000 had they chosen another alternative). Commission regret is usually much stronger than omission regret, this causes investors to have a tendency to weigh positively the alternative of status-quo (leave the investment as it is) merely because of its condition as such, and thus it is harder for them to take position changes.

If I paid for it, I want it back

The theory says that a rational investor should not take into account “sunk costs” (those that are irrecoverable) when making a decision.

Recognizing some situations in which there are possibilities of falling into these errors and thus establishing alerts will allow us to avoid them in the future.

However, it is very common to find that if a person bought a share at 10 and it fell to a price of 6, the person tends to want to wait until it returns to at least 10 to sell it and thus “recover their investment”, without even assessing what are the future prospects of the share in question. Perhaps, the decision to sell at 6 today is the best one he can make if he thinks that stock will continue to fall, but it seems that those 10 he paid didn’t quite sink in the investor’s mind. Remember this bias the next time you go to a very expensive restaurant for dinner and find yourself continuing to eat away at the dish you ordered, even though you didn’t like it, simply because of the high price you paid.

The budget allocations of the mind

Financial theory suggests that investors make their decisions based on the impact they have on their total portfolio. However, it seems that many investors divide their wealth into different accounts as if they had a kind of “mental bookkeeping” and make their decisions based on the meaning they give to each account, therefore, they are more likely, or more reluctant, to invest depending on the account from which the funds come.

The objective of this review is to recognize some situations in which there are possibilities of falling into these errors and thus, establish alerts that allow us to avoid them. Your next financial loss may be due solely to unforeseen factors but acknowledging the possibility of making these mistakes may give less room to “bad luck”, for it to become “good luck.”

Federico Esseiva
Partner at Tandem
fe@tandemsd.com

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