Over-reaction is dangerous in investment decisions

The overwhelming majority of investors tend to formulate investment strategy by naively extrapolating recent trends. 

Second, they tend to be overconfident in their ability to predict the immediate future accurately. 

Finally, their confidence intervals are skewed, which means their best guesses are not evenly spaced between their high and low estimates. 

Why does this happen? In effect, individuals are most influenced or tend to ‘anchor’ their predictions on just how salient they believe recent history is. Nobel Prize winner Daniel Kahneman suggested that we tend to judge the probability of an event by the ease with which we can call it to mind. The more vivid our memory of something similar in the past, the more probable it will seem to happen again. Remember 2008 — AIG, Lehman Brothers, Bear Stearns. 

Paul Slovic, an eminent psychologist has an explanation that is based on our intuitive sense of risk being driven by two factors — dread and knowability. His conclusion: These two factors ‘infuse risk with feelings’.

·         Dread is really a function of how dramatic, controllable or potentially catastrophic a risk appears to be.

·         The knowability of a risk depends on how immediate, specific or certain the consequences appear to be.

Therefore, our perceptions are distorted such that we underestimate the probability and severity of common risks such as inflation. On the flip side, less comprehensible risks that we have never personally experienced seem potentially lethal. 

As Jason Zweig put it, “We see the world through warped binoculars that not only magnify whatever is remote, but shrink whatever is near.” So, blinking in the face of risk might well be natural, yet the over-reaction is incredibly dangerous in arriving at investment decisions.