The decisions we take when making investments often fail because of our emotions, since we often make misguided judgements about the facts we are trying to evaluate.
This internal struggle that we face when it comes to making decisions has led to a new line of research, behavioural economics. This discipline aims to combine the most traditional economic models and the empirical observations of psychologists, and was honoured in 2002 when Daniel Kahneman and Amos Tversky won the Nobel Prize in Economics. Richard Thaler, an economist specialising in behavioural economics, went on to win the same award in 2017.
In this series of posts we'll talk about those unwritten rules that allow individuals to get a quick idea of a particular situation to help them make a decision, but which often lead us to make mistakes.
At a time when the majority of market prices are red, it is good to reflect on two basic aspects when it comes to understanding how we behave when investing in the stock market. The first of these deals with the fear of risk, which together with the fear of losses leads to the compulsive tendency to want to cut losses and in impatiently taking profits.
All of us have our reaction to certain emotions in common, so the more pleasurable the outcome, the less satisfying this will be. And conversely, the more displeasure we've had, the less we'll be affected by further displeasure.
Let's look at some examples. When we're thirsty, the first drink of a very cold beer is more pleasant than the second, and this in turn is more pleasant than the third, etc. The same thing happens when we get a compliment or praise. We get very excited the first time, but as we receive more praise our additional happiness diminishes. On the negative side of things, we prefer a heavy penalty to a number of small fines spread over a specific period of time. The same goes for children. The first punishment has an impact on them, but if we adopt a strategy of continuously punishing them, each additional punishment matters less to them and consequently they do not learn from the mistake made.
But reality shows that we are more affected by a loss than by a gain for the same amount. And in the investment world, this means that in practice we are more tempted to take risks when we are at a loss than when we have acquired an increase in value, because as each additional euro of loss hurts us more, we are willing to take risks to get out of that rut.
Faced with the possibility of winning or losing 1000 euros, the satisfaction that the profit would bring is less substantial than the pain that the loss would bring.
The basic consequences of this behavioural bias are that we keep losing securities despite the risk of losing even more, and, in addition, we sell securities that have risen very quickly in order to protect profits.
Do we keep those investments that we lose on when we are willing to take more risks? Doesn't it seem strange? This is because normally the fear of risk and the fear of loss go hand in hand. But we'll talk about that in the next post.