5 Misperceptions in the evaluation of investments

This post can be understood as part #2 of my Behavioral Finance series (see part #1: 8 Insights from Behavioral Finance that will increase your investment performance). While part #1 was about judging probabilities, part #2 focuses on the evaluation of outcomes. Avoiding these mistakes (so called ‘Evaluation Biases’) will further improve your decision making and the performance of investments.

Definition of Evaluation Biases

Evaluation biases emerge in situations under uncertainty. In contrast to judgment biases, we do not assess the probability of an event to occur but evaluate the outcome (e.g the return of an investment). Likewise, this evaluation is affected by irrational behavior which may lead to wrong investment decisions.

5 Examples of Evaluation Biases

Reference Point Dependence (1)

Investors tend to evaluate their investment decisions relative to a reference point (e.g. the status quo or the purchase price). Outcomes are either classified as gains or losses, whereas rational decision making would rest upon the final wealth. In general, people are risk averse to gains and risk seeking for losses. But what does this mean exactly?

Assume two lotteries A and B:

A offers a 50% chance to win $1,000 and a 50% chance of $0.

B offers a certain payout (100%) of $450.

While the expected value of A ($500) exceeds the certain payout of B ($450), risk averse decision makers (which is true for most of us) would prefer B over lottery A.

Now, assume two lotteries C and D:

C offers a 50% chance to lose $1,000 and a 50% chance of $0.

D offers a certain loss (100%) of $450.

If our behavior were rational, we should still act risk averse. However, many people would choose lottery C (expected value = -$500) over the certain loss of D (-$450). This behavior is called risk seeking and explains why many people prefer bonds over a stock market investment (see also the seminal study of Kahneman and Tversky).

When you think about selling a stock, the decision should not depend on the purchase price but on the expected future value.

You should ask yourself: If you did not already own the stock, would you buy it again? If the answer is “yes“, you should keep it.

Loss Aversion (2)

The loss aversion bias is closely linked to the risk seeking behavior of (1) and may explain why there is a changing risk attiude when evaluating gains and losses.

E offers a 50% chance to win $500 and a 50% chance to lose $500.

F offers a 100% chance of $0.

For most people, losses loom larger than gains, which is why they would prefer F over E. In fact, there are also people who would refuse a lottery that includes a 50% chance to win $500 and a 50% chance to lose $250. While the expected value of this lottery is clearly above zero, some people would overweight the $250 loss.

Of course, this behavior is irrational and makes you missing out great investment opportunities.

Losses and gains should be treated equally. Rest your investment decisions on expected values rather than perceived values.

Myopia (3)

Myopia describes the fact that many investments are evaluated in too narrow time frames.

Most investors focus on the most recent returns, e.g. from the last days or months, instead of evaluating a longer investment horizon. This is espcially relevant when taking into account how often the US stock market displayed positive returns (rolling windows):

  • Daily: ~50%
  • Monthly: ~62%
  • Yearly: ~73%
  • 10 Years: ~95%

While daily returns are distributed 50-50 (which is why CFD trading is basically a lottery), the proportion of positive returns strictly increases when considering long-term results. Thus, if you check the performance of your investments in shorter time periods, you will likely experience more losses which, in turn, increases the probability of selling your stocks too early.

Don’t evaluate investment decisions based on short time periods. To reduce the probability of selling your stocks too early, you should also avoid checking your investments on a daily basis.

Mental Accounting (4)

Mental Accounting is a very common bias that refers to the process of coding, categorizing and evaluating economic outcomes (Benartzi and Thaler, 1995). Most often, it is applied when budgeting expenditures.

Just think about a simple example of Thaler (1985):

Mr. and Mrs. J. saved $15,000 toward their dream vacation home. They hope to buy the home in 5 years. The money earns 10% in a money market account. They just bought a a new car for $11,000 which they financed with a three year car loan at 15%.

Okay, interest rates may not relate to today’s values but the problem is still up to date: As the loan interest rate (15%) is a higher than that of the money market (10%), Mr. and Mrs. J. should have used their savings instead of taking a loan. This beavior is common for many people because savings and loans are divided into two different mental accounts. Thus, in order to maintain their savings, people rather take an expensive loan.

Don’t create mental accounts for savings and expenses. If you have got enough money to buy a product, you should rather use your savings than taking a loan. In total, this will save you money!

Sunk Cost Effects (5)

Sunk costs are expenses that occured in the past and cannot be revoked. If people were rational, these costs should not affect decision making. However, many of us (especially politicians or companies) will likely do the opposite.

Think of the following example:

  • In 2018, a city decided to build a new airport. As of today, incurred costs amount to $30m. Additional costs to complete the airport are expected to be another $30m.
  • Instead of completing the airport, the city could also build a new (equally valuable) airport with expected costs of $20m.

What would you do? Most politicians would most likely refuse to cancel the ongoing project (as this would displease tax payers). Nevertheless, a rational decision maker would definitely choose to build the new airport.

Don’t make decisions conditional on what you experienced or incurred before. The only thing important is what you expect for the future.

Reading tip: you should also check this article from Jesse‘s “The Best Interest“ blog on personal finance and mental health.


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Author: Admin
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Bow @bankeronwheels.com

Good intro to behavioural finance!