The Ostrich Effect

The term was originally introduced by Galai & Sade in 2006, and was defined as "the avoidance of apparently risky financial situations by pretending they do not exist."

It is common knowledge that humans are pain averse. A theory explains that everything we do as humans is to reduce pain in all the dimensions it comes in (loss, failure etc.) or to increase happiness also in all its many dimensions (wealth, love, fulfillment etc.)

As such, whenever we are placed in situations where pain is on its way, it is only natural to avoid it. One animal that is known for this is the Ostrich. While it has been discarded as untrue, legend has it that in times of danger, the Ostrich is known to stick its head in the sand until the danger has passed.

It is on the basis of this that the “Ostrich Effect” of investing was created.

The term was originally introduced by Galai & Sade in 2006, and was defined as "the avoidance of apparently risky financial situations by pretending they do not exist."

Over time, the term has advanced to refer to how investors avoid exposing themselves to financial information that could cause psychological discomfort.

The idea is that investors are selective with the kind of information they take in regarding the exposure of their stocks in the stock market. In periods of a bull market where things are fine, investors tend to view their portfolios often and are found monitoring market dynamics.

However, when there is a market downturn, investors view their portfolios less often. Just the same way the Ostrich sticks its head in the sand, people may choose to avoid monitoring their investment portfolios or even looking at financial news until the dust has settled.

If it sounds ironic, it certainly is. However, because of our aversion to pain, it is our default approach as humans. It is our nature as human investors to temporarily ignore the market in periods of downturn so we can prevent ourselves from the painful losses or at least the possibility of it.

What then is the effect of choosing to pretend that a risky financial situation does not exist even when it is at its peak? There are a number of them.

This behavior, for one, affects trading volume and by virtue of this, market liquidity. In the same way market volumes increase in rising markets, they are said to decrease in falling markets.

On the upside, by avoiding the information, you prevent information that tugs at your emotions. Research has it that the more information investors obtain in the situations, the more likely they are to make brash decisions like sell off their investments at poor rates.

By temporarily avoiding it, investors have the opportunity to ride through the wave and avoid the dangers of panic.

However, on the flip side, by avoiding this negative investment information, investors lose out on information that could be relevant sometimes, to even get them out of the situation or at least broaden their understanding of what is happening – until it is too late and they enter panic mode. Ignoring bad news does not make the news go away; In fact, it can make it way worse.

A better way to do it is to detach your emotions from the process and objectively look at all the information presented so as to be aware of the dynamics of the situation. When in danger, don’t pretend it isn’t happening; rather, face it head-on.

Written by Lawretta Egba.