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In a study by James Fairweather - Martin Currie Investment Management, 2008 a number of psychological factors were discussed as they relate to making decisions about investment. They raise some interesting challenges for investors and managers because it seems that to make good decisions, you may often need to overcome human nature.
People generally are driven by emotion and the need to socialise rather than to be logical. To some extent this helps explain why we will talk to friends and family about the economy and investments and are just as likely to draw conclusions from these interactions as from empirical or factual evidence. If these two sources of information agree, then our feelings about what we believe to be the case are very strong. If they disagree, we will tend to view the empirical evidence with a healthy degree of scepticism and our emotional state (driven by social contacts) will tend to prevail.
Secondly, in making investment choices, once we have made up our minds that we have a particular view on a market, an individual stock or fund, it takes a lot to make us change our minds. In fact research has shown it can take 2 – 5 observations of contrary information, to change the opinion we initially formed. This perhaps goes some way to explaining why markets tend to run upward too far in a bull market, and down too far in a bear market. In a bull market we know that prices are getting too high, but before we change our positive opinion, we want to see more proof. This is exacerbated by the fact that as we search for more proof, the market continues to move higher.
In the face of huge quantities of information, often expressing contrary points of view, we also have trouble imposing a logical decision making process. We develop rules of thumb to help overcome the information overload, which we show great faith in although they tend not to be very accurate. To compound the problem our commitment to our first impression means it is very hard to change our minds. Paradoxically, the more committed we become, the less often we are right. Then, even if we do formulate a viewpoint that is contrary to the norm, we feel very uncomfortable having this point of view, question why we would feel we know better, and have trouble forcing ourselves to act contrary to the group. The result of these factors acting collectively across markets, is that we invariably have market bubbles and market crashes.
Perhaps we should all be careful of the discussions we have over the Christmas barbecues and family get togethers this festive season and add Investment to the banned list of subjects along with politics and religion (although given the occasion its perhaps a little hard to ignore religion). Lets enjoy beating the English at cricket and watching the boats race to Hobart. Save investment for less social occasions lest we hold our thumbs to the wind, draw strong conclusions about which way its blowing, decide to go with the flow and put a dent in the new year before its even begun.