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Psychological and Perceptual Issues that Impact Investment Decisions: Part II


25Aug 2007

Two weeks ago I shared some thoughts from the very interesting book, Inside the Investor’s Brain, by Dr. Richard Peterson. Here are some more of his insights. Some of the initial parts (e.g. feelings) are fairly self-evident but are necessary foundations for later comments and conclusions. [reminder: page numbers are in parens]

Feelings
Feelings are the result of the comparison of one’s expectations and the actual experience. So when one expects a positive event (gains in one’s investments) and this happens, there is a positive response (elation). When you expect a positive event and the event doesn’t occur, a negative feeling response occurs (e.g. disappointment). If you expect a negative event (losses in your investments), but a positive event occurs instead, you have a positive response (e.g. relief). If you expect a negative event, and it occurs, a negative response occurs (e.g. anxiety).
The intensity of the feelings experienced is the result of three factors:
a) the size of the discrepancy between expectations and reality;
b) one’s experience with similar situations; and
c) any significant associations or memories. (39)

So, obviously, the larger the gain in relation to your expectations, the “higher” you will feel. Or the greater the loss in relation to your desires, the deeper the anguish will be.

Comparisons

I find the process of comparing ourselves to others to be one of the biggest contributors to our state of emotional being. And, as I have emphasized previously, we typically compare ourselves to others whom we pereceive to be “better off” than we are (and often our perceptions are incorrect). Thus, we can become angry, disappointed, or envious. Conversely, if we compare ourselves to less well off than we are, we can be quite thankful for our lives (and sometimes feel guilty, too.)

Dr. Peterson states:
“Emotions often arise when one compares his or her life circumstances to those of others.” (40) “This comparison phenomenon occurs throughout the business world, where measures of self-esteem and accomplishment are often made tangible. Silicon Valley billionaires may feel jealous of the size of each others’ yachts, leading to a boom in the construction of ultra-luxury vessels as each tries to outdo the others. A non-billionaire sailor may feel happy simply to be in the same marina as such beautiful boats.” (41)
Peterson goes on to propose that “when one measures success by comparing oneself to another, . . . then winning the comparison makes one feel happy, but also deprives one of the motivation to continue working hard. .. Alternatively, when success is measured according to an internal benchmark, … then it remains an enduring motivation and leads to long-term excellence.: (41)

Defense Mechanisms

Sometimes we employ the use of psychological mechanisms to defend ourselves from feeling negative feelings (which we typically don’t like to experience) such as guilt or anxiety. One defense mechanism is rationalization where an individual attempts to provide a rationale (a logical reason) for their choice or behavior which created a negative result.
Peterson cites one type of rationalization investors often use called motivated reasoning. “Motivated reasoning is thinking biased to produce preferred conclusions and support strongly held opinions.” (45) [ASIDE: There seems to be a lot of this type of thinking going on in the political realm, on both sides of the spectrum.]
An important implication is that “people who engage in motivated reasoning perform more poorly on decision-making tasks than those who are less defensive about negative information. . . George Soros indicated that one of the keys to his acumen is the ability to non-judgmentally think about why his investment reasoning process may be wrong (his theory of fallibility).” (46)

Investing and Feelings

“ ‘If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring.’” [George Soros] (91)

The Jackpot Trap. Studies of individuals in casinos, reveal the following thinking patterns of individuals gambling. People tend to focus more on the size of the potential reward (the jackpot), rather than the probability of winning.
There are a number of cognitive misjudgments that occur during games of chance (and which can impact financial investment decisions, as well.) Dr. Peterson cites research that found the following:
“When an outcome is possible but not probable, people tend to overestimate its chance of occurring. This is called the possibility effect. (Frequently seen during huge lottery jackpot payoffs.)
When an outcome is likely, people to tend to underestimate its odds. This bias has been named the certainty effect.
Events of probability less than 40 percent are susceptible to the possibility effect. Outcomes with greater than 40 percent probability are in the realm of certainty effect.” (177)
“For the most part, there is dissociation between intellectual judgments of risk and emotional feelings about risk. Emotions in uncertain or risky situations are more sensitive to the possibility rather than the probability of strong consequences, contributing to the overweighting of very small probabilities. In general, naïve investors think that very low probability but emotionally loaded events (such as potential market crashes) are much more likely than they actually are. High-likelihood, emotionally weighted outcomes, such as bull markets, are assumed to be less likely than they actually are.” [emphasis added] (178)

The Anatomy of a Stock Hype

Some investment opportunities directly appeal to investors’ emotional reactions. One such deal is the “stock hype”, where a promoter attempts to hook investors’ interest and commitment by the style in which the information about the investment is communicated. Unfortunately, I could track point-by-point with him on times when I have succumbed to the pressure of this approach.  Dr. Peterson presents the following characteristics of a stock hype:

1. Novelty. An emphasis on new or overlooked areas of the market, in order to stimulate curiosity.
2. Anticipation of a large gain. Suggestions that investors could expect a “huge payoff”.
3. Information overload. Sales pitches loaded with lots of statistics such as projected revenues, earnings, projected market size. The large amount of information tends to shut down people’s ability to critically analyze the data.
4. Bargain buying. An appeal to the investors’ search for a bargain by using phrases such as “under book value” and “dirt cheap”, implying that one can’t lose by investing.
5. Author as expert. The communicator of the deal presents themselves as an expert in the area of investment, attempting to foster a trust of his recommendation. Using obscure, detailed data in one ploy used.
6. Time pressure. The deal is presented in a manner that makes the potential investor to feel as if they may “miss out” if they don’t act quickly. Individuals need to “act soon” or the offer is going to close soon. (94-95)

There is a lot of other both interesting and practically helpful information in this book. One final point from some research Dr. Peterson summarizes: we tend to make better decisions (both in life, generally, and financially) when we are rested, are eating healthily (limit fat, caffeine and alcohol), get moderate exercise, and are connected relationally to others (306-307). So go live a healthy life and have the wonderful secondary result of making better decisions, as well!

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