Why do investors irrationally rely on past performance and fail to take expected returns as well as risk into account, as modern portfolio theory suggests they should? Two behavioral phenomena may offer some answers. The first reason may be that people tend to see patterns in small series of randomly drawn numbers, and when making decisions, people attempt to impose some order or structure on the information that they see. The second reason may be that many people when faced with difficult decisions tend to rely on readily available information. A simple reason that investors may rely on past performance could be because that information is cheaply available.
The following ideas may help us understand how we make the investment decision we make. First, when we are thinking about how much we will gain, many of us are often overconfident and filled with excessive optimism.
We tend to, in our minds, build forecasts of the future that are typically too rosy. Second, when we are considering how much we could lose, risk-aversion may lead some of us to over react to what we are actually losing in our investments or because of fear of a loss, we will take investment gains earlier than we should. And third, if our decisions are less than ideal due to both overconfidence and loss avoidance, the impact of these will be exacerbated by how we have framed the issue and we tend to have narrow frames around gaining or losing money.
We tend to, in our minds, build forecasts of the future that are typically too rosy. Second, when we are considering how much we could lose, risk-aversion may lead some of us to over react to what we are actually losing in our investments or because of fear of a loss, we will take investment gains earlier than we should. And third, if our decisions are less than ideal due to both overconfidence and loss avoidance, the impact of these will be exacerbated by how we have framed the issue and we tend to have narrow frames around gaining or losing money.
One of the important findings of psychology is that peoples’ future forecasts are often characterized by widespread overconfidence and excessive optimism. Such overconfidence may partly be the result of an inability to understand accurately the role of random chance in determining the future. People are notoriously poor statisticians, and they find patterns and trends in data that could just as easily be explained by random chance.
Poor risk calculations certainly play a role in overconfidence: individuals who are “100% sure” of their responses to certain questions are usually wrong 20% of the time. Our perceived sense of control also plays a role: the stronger one’s sense of control, the more powerful one’s sense of confidence
Poor risk calculations certainly play a role in overconfidence: individuals who are “100% sure” of their responses to certain questions are usually wrong 20% of the time. Our perceived sense of control also plays a role: the stronger one’s sense of control, the more powerful one’s sense of confidence
If overconfidence helps explain behavior on the “upside” then the “downside” is dominated by aversion to loss realization. This may play out in interesting ways. For instance, as people are inclined to take a gamble if confronted with the choice of realizing an incurred but not-yet-realized loss, versus taking the gamble in which they might break or lose more. If there is a reasonable prospect of breaking even and avoiding a loss, many people take the gamble and risk losing even more money
There is evidence that overconfidence and loss-aversion are intensified by too narrow a framing of risky decisions. Few of us would take a gamble involving a 50 percent chance of winning $1,500, versus a 50 percent chance of losing $1,000.
Some studies suggest that losses are as much as twice as psychologically powerful as gains. Other studies indicate that losses are almost three times more powerful than gains. What this means is that most of us would not take the gamble until the gain was closer to $2,500. Yet experimental evidence indicates that if we are given the opportunity to accept this gamble many times, or when it is framed in terms of changes to their entire net worth we will take the gamble.
Perhaps it is more natural for us to think small when facing a one-time gamble, but because we think we may get it right over time then we think large and take the gamble.
Some studies suggest that losses are as much as twice as psychologically powerful as gains. Other studies indicate that losses are almost three times more powerful than gains. What this means is that most of us would not take the gamble until the gain was closer to $2,500. Yet experimental evidence indicates that if we are given the opportunity to accept this gamble many times, or when it is framed in terms of changes to their entire net worth we will take the gamble.
Perhaps it is more natural for us to think small when facing a one-time gamble, but because we think we may get it right over time then we think large and take the gamble.
The last phase of financial decision making for retirement happens during later middle-age and beyond, and it is the period when most people decide how they will spend down their accumulated assets. Because most of us do not know precisely how long we will live, we do not want to run the risk of exhausting our assets before dying.
We can do this by reducing what we consuming less per year during retirement, but of course this simply elevates the chances that a we might die with “too much” wealth left over. This is fine if we want to leave our wealth to our heirs, but a few years back I saw many bumper stickers that say “I am spending my children’s inheritance”, which I agree with for the most part, but today those bumper stickers are few and far between
Interestingly a recent survey reported that only one-third of the respondents knew that if someone who attained the age of 65 they had a substantial chance of living beyond his/her life expectancy.
We can do this by reducing what we consuming less per year during retirement, but of course this simply elevates the chances that a we might die with “too much” wealth left over. This is fine if we want to leave our wealth to our heirs, but a few years back I saw many bumper stickers that say “I am spending my children’s inheritance”, which I agree with for the most part, but today those bumper stickers are few and far between
Interestingly a recent survey reported that only one-third of the respondents knew that if someone who attained the age of 65 they had a substantial chance of living beyond his/her life expectancy.
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