Five common pitfalls that investors face

Five common pitfalls that investors face

Have you ever considered why despite the fact that the odds of coming up with a winning lottery ticket may be stacked greatly against a punter, there are still crowds forming at gaming outlets?

With odds stacked a mile high, it doesn’t make sense from a logical standpoint to buy a lottery ticket yet punters everywhere do not mind spending copious amounts on tickets for that one lucky break.

How is this seemingly irrational behavior explained?

Daniel Kahneman and the late Amos Tversky developed the “Prospect Theory” where they studied how people manage risk and uncertainty. Kahneman was awarded the Nobel Prize in Economics in 2002 for this work. The research showed that if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former – even when they achieve the same end result.

The research also uncovered apparent anomalies and contradictions in human behavior – subjects when offered a choice formulated in one way might display “risk-aversion” but when offered essentially the same choice formulated in a different way might display “risk-seeking” behavior.

For example, these questions were used in their study:

  1. You have $1,000 and you must pick one of the following choices:
    1. You have a 50% chance of gaining $1,000 and a 50% chance of gaining $0.
    2. You have a 100% chance of gaining $500
  2. You have $2,000 and you must pick one of the following choices:
    1. You have a 50% chance of losing $1,000 and a 50% of losing $0.
    2. You have a 100% chance of losing $500

An overwhelming majority of people chose “b” for question 1 and “a” for question 2. The implication is that people are willing to settle for a reasonable level of gains (even if they have a reasonable chance of earning more), but are willing to engage in risk-seeking behaviors where they can limit their losses.

This explains the irrational risk-seeking behavior of punters.

It also explains the tendency for investors to hold on to losing stocks for too long and sell winning stocks too soon. Of course, the most logical course of action would be hold on to winning stocks in order to further gains and to sell losing stocks in order to prevent escalating losses. But investors realize the gains of winning stocks too soon: cashing in on the amount of gains that have already been guaranteed – representing risk-averse behavior.

On the other hand, investors hold on to losing stocks for too long. They are willing to assume a higher level of risk in order to avoid a negative prospective loss. Unfortunately many of the losing shares do not recover and the losses continue to mount disastrously.

Based on studies over the decades and centuries since Adam Smith, investors have shown a set of common behaviors that are identifiable – common pitfalls that they blindly fall into.

Take a look and see if you can identify with any of the following five situations that regularly beset investors:

  1. Investors are more motivated by the fear of loss than the rewards of successful investing Investors put their money into financial instruments that they believe will reap returns. However, once they have invested, there is an overriding, irrational fear of losing the invested sum. Investors will often hold onto a losing instrument out of pride. Even when it declines in value, the investor hangs on tightly hoping that the tide will turn. When it doesn’t happen, the investor ends up losing even more.
  2. People believe what they want to believe
    Following from point no. 1, people tend to believe what they have set their minds and hearts to believe, regardless of reality. When their money and pride are at stake, even investment news and analysis are ignored. Successful investors are normally objective people, not driven by emotions.
  3. Overconfidence with small amounts of information
    When rumour mills go into overdrive, pockets of investors pounce onto bits of information to make sudden trade decisions. Again, ignoring the rational voice of sensibility, these investors would rather hang onto choice bits from the grapevine than solid research reports and fundamental data.
  4. Gambler’s fallacy
    Investors tend to be completely illogical when predicting random, future events. Ignoring the stacked odds against them, some prefer to jump headlong into an investment, for example lottery buying.
  5. Pressure to conform to others’ beliefs
    People go with the flow and make the same mistakes that everyone else around them makes. This is either due to a need for acceptance or the inability to accept that large groups can possibly be wrong. The 1634-1637 tulip and bulb craze that led to the market crash in Holland is a clear example.

These are some of the common pitfalls that investors face because of our fallible human nature. Be mindful of them, steer clear of all danger, remain focused and stay objective to invest successfully.

Reference:
http://www.moneycrashers.com (accessed on 21 January 2014)
http://www.sjsu.edu/faculty/watkins/prospect.htm (accessed on 23 January 2014)
http://www.investopedia.com/university/behavioral_finance/behavioral11.asp (accessed on 23 January 2014)