Tuesday, March 28, 2017

How Our Brains Are Wired To Make Investment Decision

We often get questions either in person or email asking us on our thought process when making investment decision.

I tried to explain on one of my articles back then here on how I generally consolidate my thoughts around what's needed to pass through an investment channel in my wired brain function before I put my money in a particular company.

We have plenty of good bloggers in the community who are able to dissect through financial numbers of companies and explain the thesis or rationale to invest in the particular company.

What the finance community is generally lacking of though is the ability to explain these thought process from the moment an idea catches up to the time the investment is materialized. This is even made harder if the person we are relaying to is a beginner in investing. It is not only the tangible portion that can be transported but the thinking process is more challenging.

Kyith wrote a good article recently on the thought process behind the expected return from an investment which I thought warrants more than a thumbs up. I feel like many people are under-appreciating the importance of having such thought process in place before they could start anything about investment.

If you are into project management or have taken a finance or PMP module previously in school, you would realize that they would like to associate it with Net Present Value (NPV).

In layman terms, NPV is nothing but an indicator of how much value an investment can return after discounting it for a specific period in time. Generally, when NPV is greater than zero, we should accept that investment because that is returning us money.

This is the same with expected return and probability because at the end of the day, we want our money to grow. The discount rate is the tricky one here to decide because they are a variable function just like probability and it would swing the result from one onto another greatly if they are different.

This is probably the reason why you see many aunties and uncles queueing up to put their hard earned money into a fixed deposit promotion campaign. If the risk of default is low, it should be generating positive returns and that's the most important part of making money work for you.

An investor would usually benchmark his or her position to another product that is offering a definite or guaranteed return (or at least it is close to 99%) such as the Singapore Savings Bond or treasury bond issued by well credit rated company or country. 

A more savvy investor would benchmark to a different product that are giving them options to weigh in between the investment decision. This is why when we usually sell our position, one of the question to ask is if there are a better product out there giving us potential greater returns. Note that I use the word "potential" because they are not guaranteed in nature and thus have to be taken into consideration. But a good investor would have weighed the risk and computed the probability of an event not happening in making the decision.

If we take out greed out of the factor, I sincerely believe that everyone can learn well from their investment by taking baby steps and understanding how our brains are wired to make informed investment decision. This can start from putting our money into a fixed deposit and then slowly moves up the ladder gradually as we begin to explore more of what we already know or not knowing. It is often because of greed that causes the pitfalls because we mess up the steps in our brain thought process by thinking that we already know something when we actually do not know and that is something that will kill us.

Embrace the fact that no one knows anything from the start and there is a learning curve to be able to know something better in the future. This way, we keep on learning and making steps on informed decision that wired our brain with our action, consciously.

1 comment:

  1. I think whatever investment decision that people made if they aren't the one who do the research themselves, it might end up in a panic sell. That's where people lose money. Because everyone looking at the chart from 1900 to now, there is only one direction, that's up! Yet, people manage to lose money. LOL :)