/ Kevin Trutmann, MSc (translated from German by Laura Wiles)
How investment position influences our expectations
Not all news is equally important. When it comes to investment decisions in particular, we sometimes let ourselves be misled by unimportant information or pay too little attention to important information.
The price of stocks is falling. But does that mean anything? And how should deal and trade with such information? Decision makers in a textbook would try to filter out the informative part of the stock price movement and integrate it into their existing expectations. Correspondingly, professional fund managers use complex mathematical models to derive the best possible forecasts.
This type of structured approach also helps to ignore unimportant aspects. For example, a statistical forecast is independent of whether the price decline has resulted in profits or losses. The ability to make objective decisions and separate important from unimportant aspects is also attributed to many successful investors.
However, we know from laboratory studies that the processing of new information by private investors is often shaped by positive or negative experiences, desires and expectations, and thus also by irrelevant aspects. For example, participants in a behavioral lab investment study tend to believe that sooner or later the price of an investment will return to the entry price (Jiao, 2017). So if the stock price has risen and a profit has been made, participants expect that there is a high probability that the price will fall and profit will be lost. As a result, many sell their investment, although all signs point to success and the best option would be to do nothing. Conversely, loss-making transactions are then held onto for longer in the hope that the price will recover.
Such considerations can also lead to a situation where our expectations for the development of a stock price depend on whether we have ourselves invested or whether we view price movements rationally “from the outside” (Kuhnen 2017; Lejarraga, 2016). In another experiment, it was shown that participants tended to “justify” their investments by, for example, simply ignoring negative information about their asset.
Maintaining this “rationality” is one of the challenges that has to be faced in investment transactions. It influences whether we can distinguish between important and unimportant information and thus give it the necessary weight—but no more.