7 Ways Your Brain Is Making You Lose Money

brain scan

Photo: Patrick Denker via flickr

“Investors are ‘normal,’ not rational,” says Meir Statman, one of the leading thinkers in behavioural finance.behavioural finance aims to better understand why people make the financial decisions they do.  And it’s a booming field of study.  Top behavioural finance gurus include Yale’s Robert Shiller and GMO’s James Montier.

It’s also a crucial part of the Chartered Financial Analyst (CFA) curriculum, a course of study for financial advisors and Wall Street’s research analysts.

We compiled a list of the seven most common behavioural biases.  Read through them, and you’ll quickly realise why you make such terrible financial decisions

Your brain thinks it's great at investing

Overconfidence may be the most obvious behavioural finance concept. This is when you place too much confidence in your ability to predict the outcomes of your investment decisions.

Overconfident investors are often underdiversified and thus more susceptible to volatility.

Source: CFA Institute

Your brain doesn't know how to handle new information.

Anchoring is related to overconfidence. For example, you make your initial investment decision based on the information available to you at the time. Later, you get news that materially affects any forecasts you initially made. But rather than conduct new analysis, you just revise your old analysis.

Because you are anchored, your revised analysis won't fully reflect the new information.

Source: CFA Institute

Your brain is too focused on the past.

A company might announce a string of great quarterly earnings. As a result, you assume the next earnings announcement will probably be great too. This error falls under a broad behavioural finance concept called representativeness: you incorrectly think one thing means something else.

Another example of representativeness is assuming a good company is a good stock.

Source: CFA Institute

Your brain doesn't like to lose.

Loss aversion, or the reluctance to accept a loss, can be deadly. For example, one of your investments may be down 20% for good reason. The best decision may be to just book the loss and move on. However, you can't help but think that the stock might comeback.

This latter thinking is dangerous because it often results in you increasing your position in the money losing investment. This behaviour is similar to the gambler who makes a series of larger bets in hopes of breaking even.

Source: CFA Institute

Your brain remembers everything.

How you trade in the future is often affected by the outcomes of your previous trades. For example, you may have sold a stock at a 20% gain, only to watch the stock continue to rise after your sale. And you think to yourself, 'If only I had waited.' Or perhaps one of your investments fall in value, and you dwell on the time when you could've sold it while in the money. These all lead to unpleasant feelings of regret.

Regret minimization occurs when you avoid investing altogether or invests conservatively because you don't want to feel that regret.

Source: CFA Institute

Your brain likes to go with the trends.

Your ability to tolerate risk should be determined by your personal financial circumstances, your investment time horizon, and the size of an investment in the context of your portfolio. Frame dependence is a concept that refers to the tendency to change risk tolerance based on the direction of the market. For example, your willingness to tolerate risk may fall when markets are falling. Alternatively, your risk tolerance may rise when markets are rising.

This often causes the investor to buy high and sell low.

Source: CFA Institute

Your brain is great at coming up with excuses.

Sometimes your investments might go sour. Of course, it's not your fault, right? defence mechanisms in the form of excuses are related to overconfidence. Here are some common excuses:

  • 'if-only': If only that one thing hadn't happened, then I would've been right. Unfortunately, you can't prove the counter-factual.
  • 'almost right': But sometimes, being close isn't good enough.
  • 'it hasn't happened yet': Unfortunately, 'markets can remain irrational longer than you and I can remain solvent.'
  • 'single predictor': Just because you were wrong about one thing doesn't mean you're going to be wrong about everything else, right?
  • 'dog ate my research'**

Source: CFA Institute

**This particular excuse isn't identified in behavioural finance as far as we know. But we can imagine someone using it.

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