These emotions influence us when investing

For long-term financial security and to increase our wealth, we should take advantage of the opportunities presented by the financial markets. This is all the more important since current accounts yield little to no interest and inflation saps our purchasing power. But our thought processes and emotions stop us in our tracks before we’ve even begun. The following three cognitive biases – money illusion, loss aversion and regret aversion – partly explain this irrational behavior.

Would you say that one franc is worth the same today as it was a year ago? In most cases you would be wrong, though you would not be alone in your assumption. Money illusion is the culprit here.

When it comes to money, people usually think in nominal and not in real terms. In other words, when you hold a banknote in your hand, you always see the same value – the nominal value. But if you were to go shopping with the same banknote at different points in the past and compare what you can buy with it, it would no longer have the same value. Inflation in Switzerland has been very low in recent years and is unlikely to rise as sharply as in neighboring countries. However, even a low inflation rate over a long period can lead to significant losses. It is thus important to factor in inflation and deflation when assessing monetary value.

Loss aversion refers to the propensity to attach more importance to losses than profits. Suppose you were to gain and lose CHF 100 in the same day; the amount is the same, but you would not assess both outcomes in the same way. The pain of losing money is more intense than the joy of gaining it.

In a study on prospect theory, Daniel Kahneman and Amos Tversky conducted an experiment on loss aversion where they let participants decide whether or not to make a bet. They flipped a coin; if it was tails, the participants would lose USD 100, but if it was heads, they would win USD 200. In other words, they had a 50/50 chance of either losing USD 100 or winning USD 200. Rationally, the expected average result would be a win of USD 50, making the bet worthwhile. However, Kahneman and Tversky discovered that the expected win had to be between 1.5 and 2.5 times higher than the expected loss for participants to make the bet.

Instead of gaining money through an investment, many people prefer not to lose money. Like the money illusion, loss aversion can deter us from investing at all. The pain at potentially losing money is greater than the pleasure of earning a higher return. Financial markets are not the same as betting, as many institutions carry out in-depth analyses which investors can use to make informed investment decisions. Nevertheless, it is a question of overcoming the fear that not everything always happens as expected. However, the longer the investment horizon, the greater the chances of success.

Sometimes we don’t make decisions based on our needs, but because we are afraid of regretting something. In doing so, we overestimate the likelihood of feeling remorse later. This phenomenon, known as “regret aversion,” is closely linked to that of loss aversion from Kahneman and Tversky’s study on prospect theory.

\Similar to loss aversion, regret aversion stops us from making sound decisions.

Suppose you buy a car and it suffers damage. You now have to spend a lot of money to repair it – more than its original value – only so as not to regret buying it in the first place. A similar phenomenon can be observed in the financial world.

Regret can also play a major role in our decision to invest for the first time. Making an investment is an active decision, whereas not investing is simply not a decision at all. You may never begin investing because you are afraid of regretting your decision in the future as a result of possible losses.

Financial markets offer many investment opportunities. Be aware of the three cognitive biases and make your decisions on a rational basis.

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