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DECISION MAKING FOR PERSONAL INVESTMENT (part 2)

In the first stage, since individuals typically process information subjectively, it is interdependent with perception in the conceptual model. Additionally, in this first stage, perception and information directly affect judgment. Normally, before individuals can make a decision choice, they encode the information and develop a representation for the problem.

In the second stage, perception and judgment can impact on decision choice. Perception-like heuristics and more deliberate strategies (judgment) are included in most decision choices.

The four concepts of “perception,” “information,” “judgment,” and “decision choice” combine in different ways to make available for individual investors with six pathways to successful decision making. The six different pathways that investors attempt to implement in order to reach a financial decision are (Rodgers 2006) the following:

  1. The expedient pathway
  2. The ruling guide pathway
  3. The analytical pathway
  4. The revisionist pathway
  5. The value-driven pathway
  6.  The global perspective pathway

The first pathway is P→D, the expedient pathway, which typically occurs in situations where a decision choice ought to be made rapidly. The second pathway is the P→J→D, the ruling guide pathway, whereby time pressures may be imperative but are not as immediate as the P→D pathway. For the P→J→D pathway, an investor frames the problem, analyzes it, and then makes a decision choice. The third pathway is I→J→D, designated as the analytical pathway whereby relevant and reliable information is the assurance of good decision choices. When utilizing this pathway, information will directly influence the judgment stage before a decision is made. Preferably, the information is predetermined and is weighted by other sources, without biases. The fourth pathway is I→P→D, the revisionist pathway by means of which information can influence the manner in that an individual investor perceptually frames the problem or situation before coming to a final decision. The information affects the perceptual frame greatly while one is aiming for a decision choice. In addition, information is considered an important piece of this decision-making process. The fifth pathway is P→I→J→D, or the value-driven pathway illustrates perceptual framing influence on information sources that impacts on judgment before a decision is made. The perceptual frame can change the information sources used to be analyzed in the judgment stage. Further, an individual’s education, training, economic, and social perspective has a major influence on how a situation is handled. The sixth pathway is I→P→J→D, or the global perspective pathway clarifies how information reinforces investors to adjust their perceptions before the judgment (analysis) stage begins. Furthermore, this pathway provides that an open-minded decision choice is more likely to be made due to new information that has been received by an investor (Rodgers 2006).

Task characteristics of personal investing such as investment type (bond, stock, real estate), time period, dividend or interest returns, etc., suggest seeking either patterns or functional relations in a situation. Pattern seeking is induced if the situation provides information that is highly organized (e.g., tables and charts of investment performance) and if individuals are required to produce coherent explanations of their invest- ments. Functional relation seeking is induced if the information is not organized in a coherent manner and if the person is required to provide descriptions or predictions. Application of individuals’ perceptions to external information can create a likelihood of mistakes, resulting in heuristics and biases (discussed below) of the perceptual system and/or a mismatch to the external information. The closer the match the more relevant is the coherence between perception and information. If the coherence between the two concepts is weak, then one of the following possible scenarios may exist:

  1. An individual investor’s framing of the problem may conflict with the external information;
  2. The information may be providing confusing signals that cannot be properly matched with their perception;
  3. The personal investor does not understand the external information; and
  4. The personal investor may not trust the quality of the information.

The expertise of investors can influence how a particular problem is perceptually framed. Experts are known to strategize and encode knowledge differently from those without the same expertise level. As personal investors’ knowledge increases, their ability to gather information, to recognize a familiar pattern, and to attend to critical indicators while ignoring less important features becomes more and more enhanced over time. In an investment environment, an effective investor is distinguished by an ability to frame the problem well. Further, individuals’ behaviors can be classified as skill based, rule based, and knowledge based. Skill-based investment behavior comprises sensorimotor performance (e.g., talking, automobile driving), which functions smoothly and efficiently without conscious attention. Rule-based investment behavior is shaped by rules and know-how that can be stated plainly by the individual investors. Knowledge-based investment behavior is effective action in unique situations, which compels a profound understanding of the nature of the situation and explicit consideration of objectives and options. The misuse or lack of use of a certain investment behavior may result in bias behavior. That is, strategies employed by individual investors are fashioned by such environmental elements as task complexity and time pressures. The following are tips/advice on how to prevent irrational/biased personal investment decisions:

  1. inclination to assign undue weight to the first evidence attained,
  2. overconfidence on information that have taken on extreme values,
  3. propensity to seek evidence that confirms the current premise (i.e.,confirmation bias),
  4. propensity to reason about only one or two hypotheses at a time (i.e., belief bias),
  5. propensity to be overconfident (illusory of control),
  6. aspiration to maintain consistency even if that means devaluing or ignoring important,
  7. confidence in illusory correlations,
  8. overly conservative expectations, and constructing conclusions on hindsight (i.e., “I knew it all along”or hindsight bias).

By the same token, on biases in probabilistic reasoning includes:

  1. to be unduly persuaded by the cognitive availability of information, and to misconstrue this characteristic for frequency;
  2. to anchor judgments on initial estimates;
  3. to access the likelihood of an event based on familiarity or stereo-typing rather than objective frequency; and
  4. to overestimate the frequency of rare events.

**This is a partial chapter from the book Decision Making for Personal Investment, written by Tim McFarlin and Waymond Rodgers**