Explaining Investor Behaviour

Monday, November 12th, 2012

Explaining Investor Behaviour

The recent receivership of Ross Asset Management has been yet another lesson in investment behaviour. Only further investigation will determine whether anything untoward has occurred, however whatever the outcome of that investigation, investors in the fund will now be nervously waiting and considering the wisdom of their decisions.

One of the principal drivers of investor behaviour is the desire for investments with returns higher than their risks. This was a key reason why Bernie Madoff was so successful in attracting funds to his investment company. His company was in fact nothing but a Ponzi scheme, where longtime investors were paid from money deposited by new investors. His consistently high returns were nothing more than an illusion. Investors driven by return often overlook the basic principle that along with high return goes high risk.

Another important factor in investor behaviour is the asymmetrical impact of profits and losses on their emotional state. The effect of a 10% loss of capital has a much more severe emotional impact than a 10% gain. The prospect of a loss is often a trigger for a quick exit or close examination of the risks, whereas if investments are making gains, investors are usually happy with the status quo.

Investors are inclined to join herds. They are quick to tell others about their investment successes and in that way, others are drawn into the same investments in the expectation of having similar success. In those situations, more credence is given to information obtained from the herd than to important documentation such as investment statements, objective reports and financial analysis. Whole communities can be taken advantage of by unscrupulous people as a result.

Consistently high returns can lead to blind faith, complacency and a false perception of risk, which in combination are a recipe for failure.

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