5 ways your brain tricks you into making horrible investment decisions

PHOTO: 5 ways your brain tricks you into making horrible investment decisions

SINGAPORE - Studies abound showing how our mental biases thwart sound investing decisions.

Value Stock Guide has compiled the five main ways this happens into a nifty infographic.

With this, you might be able to avert making a bad call at the stock market.

The five common mistakes that lead to a series of bad investment decisions are:

You do what everyone else is doing because of herd behaviour.

You confuse "cheap" with "value."

You throw good money after bad.

You practice loss aversion and that leads to bad choices.

You think the future is more unpredictable than it is.

5 common mistakes that lead to bad investment decisions

  • Your chances of success are grim.

    "The results [of the performance of wealth advisers over an eight year period] resembled what you would expect from a dice-rolling contest, not a game of skill." -Daniel Kahneman, winner of the 2001 Nobel Prize in economic sciences.

  • Warren Buffett: His average annual returns are 13 per cent better than the market (1971 - 2011).

    Sir John Templeton: Quadrupled his investment in 4 years when Hitler invaded Poland.

    Benjamin Graham: 21 per cent annual returns over 20 years.

    Peter Lynch: 29 per cent average annual returns between 1978 and 1990. Beat the market 11 out of 13 years running Magellan fund.

  • The stock market is composed of risk-takers.

    Men and younger individuals are more inclined to take risks. Women are 20-50 per cent less likely to take risks at any age level.

    Risk-taking is genetic: Carriers of the risk-averse gene take 28 per cent fewer risks.

    50 is the age at which risk-taking behaviour peaks before beginning a decline.

  • Investors often want immediate results.

    They ignore long term positives.

    Companies focus on short term results to reach quarterly numbers.

    When there is a slight tumble, investors pull out, the stock drops.

    In 2011, concerns over the Fiscal Cliff and the European debt caused investors to pull out nearly #115 billion in stock funds. In the end the market rallied to a 16 per cent total return, even when all signs pointed to an improving economy.

  • Loss aversion: The tendency to strongly prefer avoiding losses to acquiring gains.

    Introduced in 1979 by Daniel Kahneman and Amos Tversky who worked under the assumption that the prospect of losing money has a larger impact on decision making than the prospect of making money.

    If faced with a 50 per cent change of winning $200 and a 50 per cent chance of losing $100, most investors will always lean towards avoiding a $100 loss.

  • Sunk cost fallacy: The notion that a company or individual will continue to sink money into a failing investment due to the amount of time and money already invested.

    Sunk cost dilemma: The dilemma in which investors find themselves when they have to decide between uncertain success over certain loss.

  • 22: The number of milliseconds it takes for the cerebral cortex, the part of the brain concerned with decision making and reasoning, to receive news of risky information.

    The price paid for an investment should have no bearing on whether or not you should buy or sell.

    This results in:

    1. Selling a stock prematurely, and

    2. Hanging or buying more of a losing stock, known as "catching the falling knife."

  • Never buy because something looks cheap.

    Low share price does not always mean a good deal.

    Eastman Kodak: $0.20/share but bleak future prospects.

    Berkshire Hathaway Inc: More than $145,000/share but excellent future prospects.

    Always buy based on current and future prospects.

  • You think just because everyone you know is doing it, it must be the right thing to do

    Dutch tulip mania: After the introduction of tulips to the Dutch in 1593, their relative rarity and novely - due to a virus that caused their colors to change - resulted in huge spike in price, prompting investors to trade land and life savings to acquire them. After the virus spread, the price came crashing down, resulting in many people losing their livelihoods for a flower.

  • 1. Forces investors to miss out on the bottom floor of booming markets.

    Very few bought stock in now big-name companies such as Apple, causing others to follow suit. The end result was missing out on what turned out to be one of the greatest investments ever.

    Often perpetuated by the financial media.

    2. Prevents you from getting out before the market hits the top or when you sense danger.

    Emotions. not logic, rule decision making in the stock market.