Much of our psychology – and the resulting choices and behaviors – stem from a time when we foraged for food and when wild animals were more of a danger than taxi cabs. While we can still thank this hardwiring for keeping us out of actual harm, more often than not, it no longer applies in a world where we can order food from our iPhones.
This is a psychology truism when it comes to investing, too. Mix the heated emotions behind money and the complexity of investing, and you can have a psychological recipe for failure. I’ve spent more than a decade working in investing, and I’ve seen how our own minds can become the biggest deterrent when it comes to being successful in the field. As an advisor, I now help clients understand the enormous value in making rational decisions in these situations.
Just like people are able to overcome their fear of airplanes, it is possible to identify and zap away psychological traps in investing. Here are some common ones you may not be aware of that could be throwing off your game plan:
Obviously, nobody enjoys the feeling of a loss. Whether it’s in a game of flag football or in your career, we’ve all attempted to avoid that feared feeling.
You already know you hate losing, but what you might not know is that we’re naturally inclined to feel the searing pain of a loss far more than we experience the joy of a gain. Research has shown that we’re 2.5 times more likely to notice a possible loss than a gain.
Because of this tendency, you’re most likely going to pay a lot more attention when your portfolio is doing poorly than when it’s doing well. This starts becoming dangerous when you begin taking action – like with a diversified stock portfolio. Essentially, your mind will ignore history and a basic tenant of investing, that you shouldn’t sell low. Instead, your memories of all those previous times your portfolio recovered from a loss will be wiped clean, and become replaced with a burning instinct to sell.
To avoid this, you should pay more attention to your portfolio’s performance over time than to its recent losses (or gains).
Throughout life, there’s a fine line between being confident and having hubris. Often, we tend to gravitate towards the latter. Look no further than the famous study by Ola Svenson, “Are we all less risky and more skillful than our fellow drivers?”, in which an overwhelming majority of respondents rated themselves better drivers than the average drivers.
Anyone who has a basic grasp of statistics (or has been on a busy highway) knows this isn’t the case. This even happens with professional money managers. A similar study, “Behaving Badly,” was conducted on 300 fund managers; 74% of participants rated themselves better than average at their jobs.
This bias often rears its ugly head when your investments are doing well. Often, you’ll attribute it to your own skills, and overestimate your ability to pick more “winners.” This becomes dangerous when you think you can beat the market (when almost no one can), or when you make a concentrated bet on one investment. You can try to avoid this by staying cool, and realizing that chasing more gains will most likely wipe out your previous ones.
We’re social creatures who try to follow the pack. But Wall Street is often just like checking out at the supermarket: You don’t want to be the one joining the longest line.
When an investment is making the news and doing very well, most people move their money into it, and then even more follow suit. This leads to a psychological trap in investing: It makes you want to follow the herd when the price is high and getting even higher.
Here’s what you should consider instead: If everyone is buying something, know that you’re probably too late to catch most of its upward momentum.
Hot Hand Fallacy
You may have heard of “hot streaks” in sports – a phenomenon where a player or team’s victories build momentum and it snowballs into even more wins. Players like Stephen Curry of the Golden State Warriors certainly can make this seem like a reality. However, in the study “The Hot Hand in Basketball: On the Misperception of Random Sequences,” it was reported that every shot made in basketball had no effect on any other one.
Quite simply, in sports or other fields, hot streaks don’t exist. But the hot hand fallacy can lead your brain to think otherwise. For instance, if an investment class is repeatedly doing well year after year, it might seem like a “sure thing.”
Look no further than emerging market stocks to see how this will lead you astray. They had double-digit performances from 2005 to 2007, so 2008 could have appeared to be a “surefire” win. If you bet big and followed this perceived winning streak, however, it would have led to some severe disappointment when stocks lost half their value that very year.
The lesson here: While you may miss out on an occasional potential large win, you’ll also avoid the searing pain of large losses by staying the course with a diversified portfolio.
We can’t eliminate these biases in our thinking, but we can notice them. Just by taking steps to educate yourself and stay aware of how your gut can affect your decisions, you’ll be ahead of most of the investors out there.
This article was written by Forbes Finance Council from Forbes and was legally licensed through the NewsCred publisher network.
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Forbes Finance Council