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The Psychology of investing – Just Say No!

19/10/16 Wealth Management

Why is one investor more successful than the next? Is it experience, is it skill or is it luck? Perhaps it is a combination of the three? Perhaps basic human psychology has more of an impact on the decision making process than we care to recognise.

So what are the typical reasons an investor fails to secure the returns they expect:

  • Inappropriate choice of investment.
  • Sell too early – A failure to hold their nerve.
  • Unrealistic expectations.

Inappropriate investment and a failure to hold onto investments when they take a fall can be explained to a large degree by two well known psychological principles – Herd mentality and scarcity.

Follow My Leader

In his book Influence – the Psychology of Persuasion Dr Robert Cialdini explains the herd mentality using the concept of social proof. He states “one means we use to determine what is correct is to determine what other people think is correct.” He also suggests social proof has more impact when there is uncertainty.

One powerful (and unsettling) example of social proof used by Dr Cialdini is based on a murder that took place in 1964. A young woman was murdered by a lone attacker in her home street. This was not a swift attack in a dark alley but took place on the main street in full view of her neighbours. The victim was repeatedly attacked over a 35 minute period before dying of her wounds.

Brutal, yes but what makes it interesting is 38 of the young woman’s neighbours witnessed the attack at various points but not one phoned the police or made any effort to help.

The action of the neighbours has been explained by psychologists in two ways. First, with several potential helpers around the perceived responsibility of each individual is reduced. The second is more subtle and based on social proof. As nobody appears concerned anything is wrong then it must follow nothing is wrong.

As each neighbour peered out of their windows at what was happening in the street below they probably noticed several other neighbours curtains twitching. Their neighbours appeared unconcerned and turned away after a few moments so obviously everything must be under control?

It is not too great a stretch to apply this scenario to a trading floor. Let’s assume the value of an asset is crashing. The less experienced traders must make a quick decision on what they should do. They naturally look to their peers, and especially those who are seen as experienced or as influencers for guidance.

If the influencers seem calm and unflustered and doing nothing to address the fall the inexperienced trader may go back to his/her work unconcerned. This may well be the correct decision but it could also be completely wrong.

Imagine a particular influencer and those close to them pick a particular investment then (by the principle of social proof) surely that must be an appropriate investment strategy to follow. Again this may be entirely reasonable (and successful) but it is important to recognise the risks.

The Influence Of Scarcity

Scarcity is also a driver of investment decisions. It simply states that if something is perceived to be in short supply it drives up its perceived value.

An example that neatly illustrates the principle of social proof and scarcity is a current television advertisement for Caffeine based shampoo. It simply shows a number of bottles of shampoo disappearing fast and tells us that millions of bottles have been sold to date to our German neighbours.

The advertisement is significantly shorter than the average and makes no mention of the product benefits, it is simply based on the scarcity principle and the concept that if the Germans are buying it (they are logical and sensible people – are they not?) then it must be good.

Unrealistic Investment Expectations

While it has been shown undue pessimism results in negative outcomes (what medical professionals call the “nocebo” effect) it is also true, unrealistic expectations result in undue stress and often illogical responses

For example, long term research may show that investment in a particular asset class may return 4% average annual growth over a 10 year period. A new investment to the market may be offered with an (alleged) annual return of 8% over the same period. Given the long-term research and the evidence against it, perhaps it is logical to assume the take up of this new investment may be low but the opposite is often the case.

Psychological tricks like scarcity may be at work (or it may simply be greed) but once an individual has decided on a way forward what is known as the “Backfire” effect can take place. Trying to persuade an individual that a particular course of action is a bad idea, often with solid evidence, only tends to strengthen that individual’s belief that they are in fact correct.

We are all victims of our own background, belief systems and evolutionary psychological traits. If our first ancestors looked over the long grass of the savannah and noticed their compatriots running for the sanctuary of the trees then it was reasonable to also run for those trees. In general, it was not a wise move to wait around to establish the level of threat.

Before any knee jerk reaction to a particular event, it is worth stepping back and taking a moment to review if any psychological tricks are at work.

 

This blog is intended to provide a general review of certain topics and its purpose is to inform but NOT to recommend or support any specific investment or course of action. The past is not a guide to future performance. The value of investments can go down as well as up and you may not get back the full amount you invested. Tax and financial regulations can change. Any figures quoted above are correct at the date of publication.