Why Do Investors Insist On Making Bad Decisions?

5We are currently only close to the beginning of understanding behavioral economics, but it has always fascinated me as I am constantly observing irrational behavour.

I remember back in the last century speaking to a few clients who had invested in non-regulated or very expensive investments. At that time, it was beyond me as to how these sales people could convince normal thinking individuals that this was better than plain vanilla investing, despite the obvious scam or unnecessary expenses involved. Why would they go into a long-term savings plan or suffer big upfront commissions on insurance investments (it should be noted that many regulatory bodies such as the UAE do not consider 1% insurance as insurance) when any short-term returns are in many cases wiped out due to these fees and the risks involved far outweigh any long-term commitment. This is especially true as most clients will not invest for that initial intended period. Typical investment period on a savings account is about 7 years yet they are being signed up for 15, 20 or 25-year plans.

It was not until I read an article written by Richard Thaler, Professor of Behavioral Science and Economics, (he recently won the Nobel Prize), that I began to understand why we have this irrational behavior and why this is an issue for the investor and for the advice been given.

Economists tend to present logical projections on standard and complicated investment models.

Richard pointed out that while we have always assumed that investors make rational choices to suit their best interest, it is in effect not so, investors make irrational choices when it comes to investing.

If this premise that investors make rational judgements is wrong, then we have an issue. How do you turn a ship round when it is going in the wrong direction? Despite empirical evidence pointing to the fact that investors consistently make illogical decisions, then any change to the original supposition that they do make logical decisions would upset the models the economists are using. It would damage their own current business model. As such it is proving extremely difficult to turn this ship around.

Which brings me back to the irrational behavior of people buying into expensive products that fail to deliver or under deliver. In the social world we do not seek truth, we seek bonding and as such we will say things that will have us liked by our social group and peers (why would anyone go on the streets to protest against charges of corruption against their favorite politician). In fact, we are so keen to attack anyone who challenges our thinking, as someone once put it, “the reward is the pleasure of sharing an attitude one knows is socially approved”. We in fact substitute emotions for facts. I saw one statement that said, “95% of clients buy this product” Then as an individual that reads this, out goes the seeking truth and facts and switching to the need for social bonding.

This helps explain the reason why the average investor only makes half of what the market does.  Other empirical evidence shows that an advisor that uses strategies such as asset allocation, rebalancing and behavioral coaching can bring 3% or more p.a. in returns (Vanguard study).

To avoid being in the 50% of investors that make half of what the market does you have to avoid paying excessive fees on products and to achieve greater returns you should be using proper advice.

  1. Search for truth and facts
  2. Need to have Proper risk adjusted superior returns
  3. Annual rebalancing
  4. Behavioral coaching during the investment by your advisor to help you manage the emotional journey

Gordon Robertson MCSI

Me Group
Director

T: +971 50 8459216

E: gr@me-group.ae