Lesson 10: The Psychology of Investing
Investing is an inherently emotional activity. This is true for a number of reasons, but for many people, it’s simply because of the uncertainty.
Of course, a lot goes into your tolerance for this uncertainty, from your childhood experiences to your current financial position. In the end, even though we may look at the numbers and listen to analyst opinions, we are human beings. Once you accept this, you can begin to look at the common mistakes or traps your emotions and thought processes may lead to.
Psychological and Emotional Traps of Investing
Herd Mentality might be one of the most common emotional traps in human existence. It has its evolutionary origins in protecting us from predators, but doesn’t work well in the market. You should not choose to buy or sell a stock based on what everyone else is doing. In fact, many of the most successful investors are those who chose to sell in a bubble, or upswing, and buy in the bust, or downswing. Unfortunately, research shows that many investors buy when a stock is most expensive, and sell when it is cheapest, the exact opposite of what you need to do to make money.
This is because it takes courage to go against the crowd, but the trick is to do your own research, and ask yourself why the crowd might be wrong.
On a related note, many investors suffer from confirmation bias. They see what they want to see in an investment, and ignore the evidence that suggests they are wrong. Perhaps you’ve experienced something similar in your life. For example if a friend tells you that everyone is wearing blue today, you will notice all of the blue shirts and not see all the other colors, making you think your friend is right. The same can happen with investors choosing to see only positives and ignore the negatives.
To make matters worse, when we have an emotional attachment to something, we will seek out people and news sources with similar opinions, turning our personal confirmation bias into group confirmation bias!
When you suffer from irrational exuberance, you’ve begun to believe that the good things that happened before will happen again. For example “if I made money on an automotive stock last year, then I must be good at picking automotive stocks, and will make money on the next one.” Or “if the economy has been growing for several years, this means it must continue to do so.” Yet reality does not work this way, this is equivalent of a child thinking, at 19h, that because the sun has been up all day, it will never go down. The point is that, instead of treating each investment differently, and acknowledging that the market or the economy can change any given day, we get comfortable.
Another common trap is that of sunk cost. This refers to costs, or losses, that can never be recovered. It is usually used in the area of economics and business, but applies to individual investors too. To give you a normal life example, let’s say you bought a ticket for a movie next week, spending 10 euros. When the day comes, you no longer want to go to the movie, and would prefer to stay home. Do you stay home, doing what will make you most happy, or do you think about the 10 euros invested, and force yourself to go to the movie? Many people would choose the movie, which represents a sunk cost.
Similarly, when you have invested in a stock, and it is not performing or has lost money, you will tend to want to wait for the stock to recover. Even if you think you found another investment that will go up, and could replace it, you will have a natural tendency not to acknowledge the loss.
How to avoid these traps?
First and foremost, start by investing an amount you feel comfortable losing. This will allow you to worry less about the investment, and keep your emotions under control. It will give you a chance to focus on the company and the opportunity you are investing in without acting irrationally.
In this way, you will learn in a calm and focused manner, gaining knowledge and experience as you go. Be careful though! This is when you might start to feel like an expert if you’ve done okay so far, and it’s important to treat every investment like a new investment.
As you go on, to make sure you are thinking clearly and avoiding your biases or the herd, seek out opinions from people and experts who disagree with you. In other words what is sometimes called a “devil’s advocate”.
If you’ve decided you really like a certain company, say Apple, and think its stock shows all the right signs for being a good investment. Ask yourself what the negatives or weaknesses are. If you find yourself struggling to find anything negative to say, or still are very excited about the stock, begin googling for articles or reports on Apple’s stock. You will find analysts with detailed opinions on why they believe you are wrong, and in investing forums you will find plenty of people to debate with. If, after all of that, you find you’re still excited, then maybe you are right. Just don’t become too confident!
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