The world that we live in is overflowing with information. This information is easily accessible and using it to come to evidence-based conclusions can help us make the best decision for our needs. Yet this is not always practical, or even desirable.
Think about the coffee you bought this morning – did you stop to consider what coffee beans the cafe used, where they came from or how they were treated? What about the barista – do you have any reliable information on where he or she learnt to make coffee, how many coffees they have made in the past or the quality of their coffee-making? Did you compare this data with the data for the café next door? Probably not, and for good reason – you’ve got better things to think about.
Consumers are confronted with many similar choices, every day. Yet like you when purchasing a coffee, they are unlikely to attempt rigorous analysis about the optimality of a given decision. It is simply too difficult and time-consuming to compute the information and draw simple conclusions for each decision. Moreover, unless you’re a coffee fanatic, you couldn’t care less whether the beans were hand-picked or half-city roasted – you just want the satisfaction that comes with sipping on a cup of coffee.
Mum-and-dad investors behave the same way when making investment decisions. Most of them are entirely disinterested in investing. Meaningful comparisons between investments are difficult to develop. This is not due to lack of available information– investors purchasing an asset will likely be able to access its annual return over several periods, national exposure, asset class exposure and a plethora of forecasts published by research houses. Rather, it’s because they are unable or unwilling to organise and summarise this information to hand.
Emotion trumps logic
So then, in this information-rich world, how do investors make decisions at all? The key lies in recognising the counterpart to rationality – emotions.