Three insights for smarter financial decision-making
Have you heard about Nvidia (NASDAQ: NVDA)? In 2023, this stock went ballistic, up a whopping 240%, making waves everywhere. The talk of the town? The AI revolution, and Nvidia’s smack bang in the middle. The burning question on everyone’s lips: ‘Should I hop on board before this rocket takes off?’ This is a classic toss-up—grab the opportunity or watch it pass by like the last few, aye? Says someone who missed the bitcoin rush and the once Aussie favourite stock Afterpay.
Here are some insights that will assist you to navigate the investment space.
Assessing risk: making informed choices
Consider this scenario: two investment options on the table. Option A offers a potential 63% gain but also carries a 77% risk of loss, while option B guarantees a 4.5% return. Many opt for A. Yet, when faced with the harsh reality of losing your investment, regrets may surface. Does this ring a bell? Turns out, Option A refers to Nvidia stock and Option B is the current yield on the 10-year Aussie government bond.
When evaluating an investment opportunity, the primary concern revolves around the level of associated risk. Most people have an emotional rather than an objective understanding of risk. They often equate high risk with high reward, neglecting the fact that high risk also comes with a higher probability of severe losses.
Now, an economist would tell you this regret you experienced is called loss aversion bias. It occurs when you feel more pain from losing money than pleasure from gaining money. However, have you ever questioned yourself: why did you choose A at the first place if you weren’t willing to accept the risk of losing?
Loss aversion complicates people’s emotional understanding of risk. Thus, having a more informed and objective understanding of risk serves as a crucial first line of defence against making suboptimal investment decisions.
This holds particular relevance in today’s markets, where new themes and instruments (NFT, SPAC, Cryptocurrency, 0DTE, ARKK, TSLA) constantly vie for investors’ attention. Just like riding a wave, risk adds thrill to life. But get it wrong with your investments, it can wipe out your financial wellbeing.
When assessing investments, a rational investor should ask the following questions:
- What is my risk tolerance level? i.e., how much am I able to lose without jeopardising my lifestyle.
- What is my risk appetite? i.e., once I know the risk I can afford, how much risk am I willing to accept?
Having a high tolerance and appetite usually indicates lower levels of risk aversion, while a low tolerance and appetite suggest higher risk aversion. As a result, your risk aversion level should guide the choice of investment products that suit your circumstances.
Having gained an objective understanding of risk, you might concur those investments like Bitcoin, known for their volatility, aren’t suitable for everyone. Conversely, a risk-seeking investor shouldn’t lament substantial losses. Embracing risk means acknowledging the potential for losses and accepting them as part of the investment.
Yet, embracing investment losses doesn’t mean neglecting due diligence. This leads to the second mistake commonly made by investors.
Avoiding herd mentality: independent decision-making
Herding in investments is a bit like a mob of kangaroos hopping in the same direction. While each might have its own path in mind, they often stick together, following the lead without checking for safer routes or better opportunities elsewhere.
Herd mentality bias occurs when investors make decisions by basing their choices on what everyone else is doing. ‘What’s the problem with riding the AI wave?’ you may ask when considering buying the Nvidia stock everyone else is buying. Purchasing Nvidia stock isn’t inherently problematic. However, it’s crucial to consider the reasons driving your decision.
A solid investment ought to present an appealing risk-adjusted return when weighed against other available opportunities. In simpler terms, it should offer a satisfying reward commensurate with the risk undertaken. For Nvidia stock to warrant a higher price than its current trading value, it needs to outperform the market’s expectations by generating stronger future earnings. This proposition is inherently subjective, because no one knows the future with certainty, including Nvidia’s CEO Jensen Huang. If your own research suggests that it might be the case, perhaps Nvidia is worth considering. But if you are buying because old mate Barry and his mates are getting in, it could be a dangerous move. Because herding can lead to investors buying stocks that are already overpriced. When the herd shifts direction, investors who followed the trend late could suffer significant losses.
To avoid such biases, you should make investment decisions based on your own research, personal circumstances, and goals. You should also be wary of investment advice that seems too good to be true.
Overcoming overconfidence: a strategic approach
After conducting thorough research, you invested in Nvidia with strong conviction, marking it as your first stock. Nvidia rallied another 30% in just two months, leading you to believe that investing was easier than anticipated. Encouraged by this success, you expanded your portfolio with three more stocks in the AI space. Two of these investments yielded profits, while one stagnated. This streak of wins reinforced your confidence, prompting a shift towards a more opportunistic approach. You started relying on gut feelings rather than carefully researching and considering alternative options.
Six months later, governments worldwide implemented new regulations on AI governance, exerting immense pressure on future growth prospects for the sector. As the market began to panic, you found yourself losing nearly half of your invested capital. Amidst the turmoil, you’re left wondering where things took a turn for the worse.
This would be a classic case of overconfidence. Overconfidence bias occurs when investors overestimate their ability to make investment decisions. This bias can lead to excessive trading, chasing hot stocks, and ignoring sound investment advice. Overconfidence in investing is a lot like the hot hand fallacy. In cricket, a batsman hitting several boundaries successively might lead to the perception that they are in a “groove” and more likely to continue scoring well. However, the reality remains that each ball bowled to the batsman is independent, and past successes don’t significantly impact the chances of future successes.
To overcome overconfidence bias, you should develop a sound strategy after gaining a more systematic understanding of investing. ‘Is there a shortcut?’ you asked. Taking shortcuts often leads to long detours in disguise. But if you must take one, it may be best to diversify as much as possible.
Diversification in investing is a bit like having a barbie with various types of snags. You don’t just throw on one type; you mix it up with beef, pork, and lamb snags. If one type burns, you’ve still got the others sizzling away. Similarly, in investing, you spread your cash across different types of investments, so if one doesn’t cook up profits, the others might keep things sizzling for you. But remember, your choices must be genuinely promising and sufficiently different; otherwise, they will burn at the same time!
Going forward
Ultimately, investment mastery isn’t solely about making money; it’s about not losing it. Tackling common behavioural biases plays a crucial role in safeguarding your wealth. Never confuse investing with gambling; successful wealth creation involves building a resilient fortress that shields you from the financial storms in the decades to come.
Disclaimer
The information provided is for general informational purposes only and should not be considered as investment advice. Any investment decision should be based on individual research, analysis, and consultation with a professional advisor, and it’s important to consider your specific financial situation, risk tolerance, and investment goals before making any investment decisions.
Author
Dr John Fan is a Senior Lecturer in Finance at Griffith Business School. He is also a consultant to institutional investors and the Director of Griffith Student Investment Fund––with $400,000 of funds under management. John’s research interests lie in investment management, with expertise in Quantitative Strategies and ESG Integration. John was awarded research grants by the Europlace Institute of Finance, and the Accounting and Finance Association of Australia and New Zealand Association. From 2015-20, John coached Griffith University teams to 4 State Championships, 5 National Finals and two Asia-Pacific Finals of the CFA Institute Research Challenge.