Why do we make poor investment decisions and how to avoid them

Debating every possibility after an event is something we all do routinely. With the benefit of hindsight, we seem to know and analyse very well how something came to be, and what should have been done. One would then assume that this knowledge would make us better off. Everyone would know what should be done to win, and would do it without a qualm. It doesn’t happen this way. Not in politics, nor in personal finance. We make mistakes again and again.

There does not seem to be a cure for poor investment decision-making. Why? We are not great at making informed decisions, say behavioural scientists. When it comes to investing, it seems to hurt us even more. Consider some common behavioural patterns most investors exhibit.

Conversations around investing tend to focus somewhat disproportionately on outcomes, not processes. People passionately describe how they bought something and it rose to become a multi-bagger. Or about how they stayed away from the markets and the crash came as expected. Any attempt to divert that conversation towards how to make it happen again usually fails. If something cannot be replicated and it won’t lead to the same outcome again and again, it is a chance event. However, investors do not like to ascribe the outcome to chance or luck. They are likely to think that having got a positive reinforcing outcome once, or a few times, is enough. That is why we have tips and tricks, short-cuts and formulae, patterns and trends, and the whole bag of tricks that leads many into making poor decisions based on overt focus on what happened, rather than the why or how.

The few lucky instances tend to become big stories. He is a millionaire today because he bought that IPO; he is a smart day trader who can multiply money magically; he is the businessman with the ability to make every venture a unicorn, and so on. These stories and legends create an aura of method. Investors begin to believe that they have acquired a competence that is valuable. Every bull market will have its narrative, its ‘fundamental’ story, its popular jargon, and a framework that everyone will buy into. Another round of poor investment decision-making is in order when these two instances combine: a chance outcome that is glorified as an exceptional competence. Everyone is then India’s own Warren Buffett.

There are more elements at play that perpetuate the processes of poor investment decision-making. Bring in social acceptance and approval. If others are in it, it seems like a good choice. A bull market attracts more and more investors because those who came in earlier have already made money. They have established that the outcomes are gainful for those who buy. They have added the aura of new, that makes it different this time. Then it becomes tough to not be a part of that party. The mere presence of others offers confidence.

There is another behavioural limitation at play—the fear of being left out. Many poor quality IPOs and ventures get investors’ money even if they are grossly overpriced because investors do not want to be left out. Playing on this eagerness of the investor has been at play for a long time: creating ‘exclusive’ offerings, shutting the gate after the first tranche, asking to decide here and now, and so on. The world is full of instances where investors have gatecrashed into absolutely ludicrous investment ideas.

There is a need to sense privilege or feel smarter than the ordinary others. Why would they not seek information and lean on what the data shows, rather than focus on how they feel? That path is also strewn with obstacles. First, there is an overload of information. It is tough to sift through various reports and recommendations strewn with data and analysis, and each one arriving at diametrically opposite conclusions. Second, there is a trust deficit at play. Investors do not know if opinions being offered are backed by expertise. They fail to identify vested interests. Third, information is selectively used when they suffer from confirmatory and availability bias.

If asked to decide in the midst of a bull market, investors may seek information that confirms the markets would continue to rise. The best evidence that they are reaching new highs every other day is the most recent and available information that seems more pertinent than theories about market cycles. Research may establish that winners don’t repeat themselves, or that it is nearly impossible to pick tomorrow’s winner today. But investors decide on the basis of the current winner that looks good today, that is being chased by everyone, and is appreciating in value in the most recent period. Money always flows in the hope that it will keep rising.

What should one do instead, one may ask. This story has been told so many times. A simple market index bought and held for the long term would do quite well for most investors. How boring, most would exclaim. Here is the list of stocks and list of funds that did better than the market, they would say. But how would you pick these? How would you know in advance that you are picking well? Do you know enough to do that? Even if you did know, would you always be right? Wouldn’t it all average out? Isn’t this the same as the market index? Not everyone is interested in these questions.

Investing has come to mean a flurry of activity. One must go about acting with assumed expertise, buying, selling, booking profits, revising and reworking. This has come to represent dynamism and intelligence. Keeping it simple and staid over the long term is boring in comparison. Poor investment decision-making is here to stay. We will crib about outcomes for a while, and then go back to doing the same things again.

The author is CHAIRPERSON, CENTRE FOR INVESTMENT EDUCATION AND LEARNING