An Australian-first training program created by researchers at Monash University could help investors train their brains against the urge to hold onto bad investments instead of cutting their losses.
The findings by Dr Kristian Rotaru from Monash Business School and his research collaborators could be the basis for new schemes that teach people how to make better financial decisions.
It starts with overcoming the human tendency to fixate on what we paid for something and the natural unwillingness to walk away without making a profit.
“We proposed and tested a new cognitive training scheme that exploits the human capacity to abstract from one’s own history to overcome unnecessary fixation on the past purchase price. This theory applies to any market where assets can appreciate or depreciate, such as a car or home,” Dr Rotaru said.
The researchers conducted three separate tests with 68 participants across four-week intervals at the Monash Business Behavioural Laboratory.
This clinical test, the first of its kind in a financial setting, tracked the eye movements and the skin responses of each participant to assess their emotional arousal after being exposed to a number of scenarios.
Initially, in a simulated scenario, the participants were investing their own capital. However, the investment approaches of each individual changed when they were asked to guide the financial decision-making of a colleague or client in a hypothetical business environment.
“Once you really want to help someone, you become a more ‘procedurally rational’ decision maker – with a tendency to follow a specific strategy that could be potentially explained to the client. People may not find it as easy to convince their client to hold on to a losing asset for too long in the hope of market reversal,” Dr Rotaru said.
Previous studies suggest that the disposition effect – the theory where investors sell at a profit and hold onto their losses – occurs when investors become more risk-seeking with loss-making assets. Additionally, investors want to avoid regretful decision-making and are prepared to wait until the stock makes a profit to justify their initial decision.
Dr Rotaru says the next step is to train people to become better decision-makers, especially those who are investing on behalf of other people.
“The research actually opens a new chapter in designing the interventions or schemes that generally improve financial decision-making,” Dr Rotaru said.
The study is a join collaboration between Dr Rotaru; Professor Peter Bossaerts and Dr Nitin Yadav from the University of Melbourne; and Professor Petko Kalev from La Trobe University.