Many people complain they have bad luck when it comes to investing in shares. While luck may certainly play a part, more often than not the problem is one of bad decisions about buying and selling. Underlying the bad decisions are psychological factors, the study of which is termed behavioural finance. We allow emotion to interfere with logic when it comes to making choices simply because our brains are wired that way.
Scientists working in the field of behavioural finance have shown that if something has happened in the recent past, people tend to exaggerate the probability that it will happen in the future. Take the Global Financial Crisis, for example. As a fairly recent event, it is seen by some people to be likely to occur again in the near future, yet such events are rare. This fear can drive people to invest more conservatively or to panic and sell when share prices start to fall. Loss aversion is another problem. People hate losses far more than they enjoy equivalent gains. If you lose $5,000, the degree of worry or distress you feel is far more than the degree of joy you feel if you gain $5,000. This exaggerated fear of loss can cause panic selling which ironically leads to loss. Then there is the issue of ‘probability neglect’. For some reason, we tend to focus on worst-case scenarios without thinking about their probability. We envisage market meltdowns but we don’t consider how likely they are. Yet another mistake we make is to sell investments too quickly when they go up in price while holding onto them too long when they drop in value. If your emotions come in to play when you are investing, think about whether any of these factors apply to you before you make a decision.