» Learn the Basics of Mutual Funds » Investment Psychology Explained

Investment Psychology Explained

Our reasoning is often subject to "cognitive illusions" much in the same way as when our eyes are tricked by optical illusions. We often unconsciously self-delude ourselves by not admitting mistakes we have made. Additionally, we commonly passionately defend the mistakes we have committed without realizing that we are in the trap of an illusion.

Falling under the control of illusions is encoded in our human nature. Therefore, we should concentrate our efforts into exercising a greater control over the fallacious thinking. If you succeed in this endeavor only then you will develop yourself as a successful investor steadily landed on the ground.

Framing Explanation

Under framing we understand the influence of the exact presentation of the information over us. This means that the delivery of the information sufficiently determines our response to the information.

Let's consider the following example in order to further clarify the concept. An investor X has been told that a certain investment opportunity has a 10% risk of failure and bankrupt. On the other hand, another investor Y has been told that the same opportunity has a 90% success rate and a 150% return of investment.

As a result, investor Y was more inclined to seize the opportunity, whereas investor X declined to do so. So, both investors were under the influence of framing since they determined their recommendations on the basis of the way in which information about the investment opportunity was presented.

The source of this type of problem is that we don't take into account the final results, but instead a deviation from a certain baseline. This is not due to some undetermined factors, but instead it is because of our human nature. To clarify this, let's further develop the previous example. Investor X is pushed into thinking in terms of a departure from the baseline (10% failure rate), whereas investor Y's frame has been changed in such a way so that he thinks about a proximity to the baseline (90% success rate). We rarely concentrate on the final asset, but instead we are constantly being pushed into thinking in terms of departing from a starting position.

No one is protected from falling under these illusions and committing the same mistakes. Nevertheless, the chances of delusion can be greatly decreased if we clearly understand the essence of framing, and constantly test ourselves to see whether we are not under cognitive illusion.

Framing in Investing

The investment field abundance of examples in which framing is observed. Moreover, brokers often use it to attract clients to use their services, by constructing their sentences in such a way that a positive attitude and image toward the broker is created. Many brokers make use of framing by persuading them to ignore the stock's market average as the appropriate baseline. Instead they are framed to believe that return numbers or previous year performance should be followed. Occasionally, investors base their investment decisions on the basis of what has happened in the past, thus ignoring the overall situation of the market and taking out a year out of the context.

Consider the following case. You have purchased shares of a particular company, but a decrease in its price has been observed. Nevertheless, you still consider it a good parking place for your money due to studies you have done. You start wondering about the potential causes for the drop instead of ask yourself whether you have really assessed the situation correctly.

But, you are committing a fundamental mistake by wrongly determining the scale. Firstly, you have selected the price as a measurement criterion, which represents an inappropriate choice since the market does not care about the price at which you have purchased the shares. As a result you may end up making the wrong judgments about the company or business you have put your money in. Secondly, you have selected time duration as the other benchmark. This criterion may be misleading since you may not have been for enough time in the company in order to draw reasonable conclusions. For some companies even six months may not be enough to be able to make logical conclusions for the investment performance.

Even though illusions can be quite tricky, there is always a crumb of truth in it. We frequently believe to statements that appear to be true, but actually are not. Moreover, illusions possess the quality of being persuasive enough to make the investors in particular risk their money. It is our goal to educate us in a considerable state so that we can distinguish the illusions form the truths.

Rate this article : Low
  • Currently 2.9/5 Stars
  • 1
  • 2
  • 3
  • 4
  • 5