Lorraine J. Green, Contributor Coherent reasoning and prudent decision making are not traits which are as widespread as we are led to believe. Many of us react to simple every-day occurrences such as early morning traffic, water lock-offs, or the West Indies cricket team losing another one day or Test match in ways which could be deemed as 'rather shoc-king displays of strange behaviour'.
Our behaviour is no different when it comes to money and investing and we often discover that we are not as rational as we think we are.
In recent years, an entire field-of-study has been developed to research, document and explain how human emotions influence investors in their decision making process.
This area of study, behavioural finance, provides theories that may help you to determine the extent to which you always act in your best interest when it comes to committing your capital to an investment vehicle. Lets examine three of those theories.
REGRET THEORY
This theory deals with the emotional reaction people experience after realising that they have made an error in judgment, whether it manifests in them acquiring the shares of a low-quality business or selling an excellent company.
In order to avoid feelings of regret, the investor's conventional 'wisdom' dictates that he or she should do what everyone else is doing. Oddly enough, most of us feel less embarrassed about losing money on a popular stock that half the country owns, rather than losing on an unfamiliar or, worse yet, an unpopular stock.
MENTAL ACCOUNTING
This theory delves into the human tendency of placing particular events into mental compartments and then gauging our behaviour based on the level of importance that we have ascribed to these compartments.
Let's look at an example.
Say you went to the local theatre where the cost of the ticket was $100 each. When you get there, you realise you have lost a $100 bill. Do you buy a $100 ticket for the show anyway?
Behavioural finance found that approximately 80 per cent of people in this situation would do so.
Now, let's say you paid for the $100 ticket in advance. When you arrive at the door, you realise your ticket is at home. Would you pay $100 to purchase another? Only 40 per cent of respondents would buy another.
Notice, however, that in both scenarios you're out $200 -- different scenarios, same amount of money, different mental compartments.
LOSS/AVERSION THEORY
It is a common truth that people prefer a sure investment return to an uncertain one we want to get paid for taking on any extra risk and that is quite reasonable.
On that note, the theory suggests that, contradictorily, individuals express a different degree of emotion towards gains than towards losses.
Individuals are more incensed by prospective losses than they are delighted about gains. An investment advisor won't get flooded with calls from her client when she has reported a $500,000 gain in the clients' portfolio.
You can bet, however, that a lot of phone calls will be received by the advisor when she posts a $500,000 loss!
To many market players, 'a loss always appears larger than a gain of equal size when it goes deep into our pockets, the value of money changes.'
That said, now that you have seen the theories, as yourself which, "Where do I, as an investor fit?"
Certified financial planner Cathy Pareto sums it up quite nicely when she asserts that "investors can be their own worst enemies. Trying to outguess the market doesn't pay off over the long term. In fact, it often results in quirky, irrational behaviour, not to mention a dent in your wealth. Implementing a strategy that is well thought out and sticking to it will help you avoid many of these common but not sound investing practices."
Lorraine J. Green is wealth manager at NCB Capital Markets, contact her at
1-888-4WEALTH or info@ncbcapitalmarkets.com
