Rational Investing. How to Reduce the Negative Influences from Emotions and Personal Biases on Investment Decisions

A short reflection


Essay, 2017

8 Pages


Excerpt

Table of Contents

1 Introduction

2 Rationality in Risk Perception and Decision-Making

3 Strategies to Reduce the Negative Effects of Emotions and Biases
3.1 Reducing Trading to a Minimum
3.2 Diversification
3.3 Earning the Market Return

4 Conclusion

References

1 Introduction

Investing money provides great opportunities, but also bears great risks. The market is unforeseeable no matter how much experience you have or how many books you read. Consequently, there is not the one right thing to do in order to be successful. However, there are some guidelines that can reduce your personal risk, help to control personal biases and make our decisions more rational.

On March 10, 2015 Prof. Dr. Dr. Martin Weber from the University of Mannheim gave the presentation “Are we rational – Insights from Behavioral Finance Research” in which he explained how emotions and biases affect our decisions and pointed out the consequences that irrational behavior can have on investing. On the basis of this, I want to elaborate some basic principles and investment strategies that have been proposed to reduce the effects of emotions and biases and foster rational decision making.

In the first part of this paper, I will summarize some of Weber’s findings on how humans are influenced by emotions and biases when interpreting information and making decisions. The second part will focus on how (i) reducing trading to a minimum, (ii) diversification and (iii) aiming for the market return can help to control personal biases in investing.

2 Rationality in Risk Perception and Decision-Making

When evaluating the profit potential and risk of an investment, a rational human being would consider objective measures, such as the expected return, the standard deviation or the beta factor measuring the correlation of a firms return with the market return. However, according to behavioral finance, humans do not act rational when making investment decision. Instead they are often influenced by emotions and biases that take the focus away from objective decision criteria and lead to irrational decision making (Weber, Borgsen, Glaser, & Norden, 2015).

According to Weber, there are two factors that influence how human beings make investment decisions:

1. Individual perception of investment risk,
2. Personal attitude towards risk.

Although every investment has an objective risk, the individual perception of risk varies from one person to another. Outside factors such as the presentation format, timing, personal experience or cultural influences affect how the risk of an investment is subjectively perceived by a person. Once the subjective risk perception is determined, the personal attitude towards risk determines the final investment decision. The higher the personal level of risk aversion, the more negative that person’s decision making is affected by one unit of perceived risk. As a consequence, the person is less likely to make investment decisions that carry high levels of perceived risk.

These personal biases within people are different from one person to another and lead to irrational decision making. For example, an investor who has repeatedly gotten high returns on his investments during a period of economic growth might falsely attribute this success to his own knowledge and skills as an investor and develop an overconfidence. As a result, he is likely to underestimate the objective risk of investments in the future and make suboptimal decisions.

Weber argues that in order to make optimal investment decisions it is essential to stay rational and to not let emotions and biases influence your actions. Therefore, I will use the following section to discuss some strategies that may be used to reduce the influence of biases.

3 Strategies to Reduce the Negative Effects of Emotions and Biases

In this section I will discuss the following three investment strategies that can help to control and reduce negative effects of emotions and biases und foster rational decision making:

1. Investing is most successful when trading is reduced to a minimum,
2. Diversification lowers investment risk,
3. Rational investors aim for the market return instead of trying to outperform the market.

3.1 Reducing Trading to a Minimum

Every time you buy or sell a security on the market, trading costs occur (e.g. commissions, slippage or the bid/ask spread) which reduce the returns from an investment. Thus, more you trade, the higher are your transaction costs.

On the other hand, time has shown that the long-term development of securities is generally positive. This may not be the case for every individual stock, but the value of a well-diversified portfolio, spread over different industries and geographical regions, has proven to increase in the long run. For example, the DAX index (consisting of the 30 largest German companies) generated an average annual return of 7.3% between 1964 and 2014 (Deutsches Aktieninstitut e.V., 2015). Similarly, the Euro Stoxx index (consisting of the 50 largest and most liquid stocks in Europe) has earned an average annual return of 7.3% between 1986 and 2015 (Deutsches Aktieninstitut e.V., 2016).

By limiting trading to a minimum, an investor can reduce transaction costs and benefit from this positive long-term trend of the market without risking to be misled by emotions to trade stocks at an unfavorable time.

3.2 Diversification

The earning streams of different businesses are generally less than perfectly correlated. This means that if the earnings of one firm change by a certain percentage the earnings of other firms do not usually change by exactly the same number. The lower the correlation between two companies, the greater is the difference between their earning streams.

By including a wide variety of different businesses in a portfolio, a large change in value of one investment will only have a small impact on the performance of the whole portfolio. This way investors can reduce their risk and make the overall return of their portfolio more steady. Exact correlations of two businesses, the correlation of a business with the market or the risk of a given portfolio can be calculated and are a part of most introductory finance books. As a rule of thumb, a well-diversified portfolio should be spread over several different industries and geographical areas to reduce risks that are industry or country specific.

Without actively pursuing diversification, personal biases may lead investors to unnecessarily increase their risk. Germans, for example, have a tendency to make outstandingly high investments into German Stocks (Weber et al., 2015, p. 126). This predominance of one country in a portfolio decreases the level of diversification and makes the returns more vulnerable to fluctuations in the German economy.

3.3 Earning the Market Return

Eugene F. Fama (1970) popularized the concept of an efficient market, in which all available information is already incorporated in the current price of a security. As a consequence, it is not possible to beat the market by purchasing undervalued stocks or selling overvalued ones.

[...]

Excerpt out of 8 pages

Details

Title
Rational Investing. How to Reduce the Negative Influences from Emotions and Personal Biases on Investment Decisions
Subtitle
A short reflection
Author
Year
2017
Pages
8
Catalog Number
V901967
ISBN (eBook)
9783346264336
Language
English
Tags
rational, investing, reduce, negative, influences, emotions, personal, biases, investment, decisions
Quote paper
Sonja Brauner (Author), 2017, Rational Investing. How to Reduce the Negative Influences from Emotions and Personal Biases on Investment Decisions, Munich, GRIN Verlag, https://www.grin.com/document/901967

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