Investment Psychological Traps To Avoid

Much of financial theory is based on the idea that investors seeks to maximise wealth.

While this is generally true, there are unique situations when human psychology guides these same investors to use ineffective decision-making processes. 

If you hadn’t noticed, people can be unpredictable and irrational at times! 

Understanding these irrational thought processes will make it much easier to spot and avoid them, especially if you’re investing in the stock market. 

1. ANCHORING BIAS

Mental constructs are ideally based on accurate facts. 

But this isn’t always the case. 

We sometimes use an inaccurate or irrelevant fact as the primary basis for all related decisions. 

You might think that this doesn’t apply to you, but faulty anchoring is very common, especially in new or unfamiliar situations. 

We’ve all heard that an engagement ring should cost about the same as two months’ salary. 

How did we get this reference point? This is an idea promoted by the jewelry industry. 

The novelty of purchasing a diamond causes us to seek out rules and reference points. 

The jewelry industry is happy to oblige. 

Most people cannot afford two months of salary to purchase a ring, but they’ll do it anyway because that’s the rule. 

How Does This Affect Investments?

In investing, anchoring comes into play when you rely too much on the use of expired or irrelevant information to make investment decisions — a psychological benchmark that influences you too much. 

For example, suppose you purchased a company’s stock at $100 and you sold it at $300.

Now that the price increased to $400, will you buy it again? Less likely, because it is already higher than the price points of $100 and $300, which were your anchors/reference points. 

Source: The Decision Lab

How To Avoid Anchoring Bias?

The best solution to avoiding poor anchoring is using logical and critical thinking skills. 

Consider whether your decisions are based on facts and rules that are accurate and relevant. 

It’s common to be uncomfortable in unfamiliar situations, but that doesn’t mean you should just grasp at things that lower your level of discomfort. 

2. HERD BEHAVIOUR

Herd behaviour is very common in humans. This is the tendency to go along with the group. 

Most people use a different decision-making process when alone versus when with a group. 

The most common explanation for this type of behaviour is the social pressure to conform. Most people likes to be accepted into a group. 

The other reason is more rational. 

People make the assumption that so many people couldn’t possibly all be wrong. Even if you feel the opposite, you might change your mind when you see so many people believing something different than you do. 

This is more common in unfamiliar situations where you lack knowledge and experience. 

Source: Franklin Templeton

How Does This Affect Investments?

Herd behaviour doesn’t correspond with successful investing. 

Buying and selling financial instruments to follow the latest trends usually doesn’t work well. 

By the time something becomes a trend, it’s frequently too late to profit. 

Throughout financial history, herd behaviour has been the cause of many a speculative frenzy in the stock market, like the dotcom bubble of the late 1990s — and the recent GameStop and Dogecoin craze.  

How To Avoid Herd Behaviour?

Following the crowds can be tempting. It’s more comfortable to be part of the group. 

But just because everyone is investing a certain way doesn’t mean that it’s the best way. 

Always do your own research and make intelligent, rational decisions. 

The herd can frequently cause investments to become over-valued. 

3. PROSPECT THEORY

People tend to evaluate gains and losses in different ways. 

It would seem that the likely net outcome would be the primary criteria for making a decision, but that isn’t the case. 

Research has shown that we process losses and gains differently. 

The concept of “prospect theory” was created from a classic study performed in 1979 by Kahneman and Tversky. 

The study demonstrated that people will make decisions based on believed gains, rather than losses. 

This means that when people are given two choices with identical outcomes, they’ll choose the option expressed in terms of the gains. 

The study presented the following questions: 

You have $1,000 and must select one of the following choices: 

  • Choice A: You have a 50% chance of gaining $1,000, and a 50% chance of gaining $0.
  • Choice B: You have a 100% chance of gaining $500.  

You have $2,000 and you must select one of the following choices: 

  • Choice A: You have a 50% chance of losing $1,000, and 50% of losing $0. 
  • Choice B: You have a 100% chance of losing $500. 

If the research subjects were consistent, they would’ve chosen ‘A’ or ‘B’ in both questions. 

But for the first question, ‘B’ was chosen by nearly all of the participants. And nearly everyone chose option ‘A’ for the second question. 

Note that in both cases, option ‘A’ meant the same thing, and option ‘B’ has the exact same result of $1500. 

It makes no sense to choose ‘A’ for one question and ‘B’ for the other. 

The issue is that most of us automatically avoid the perception of loss. 

Consider that the pain of losing $100 is probably greater for you than the happiness gained by finding $100. 

We try to avoid loss more than we try to seek gains. 

How Does This Affect Investments?

To avoid loss, there could be tendency of investors to hold onto losing stocks for too long. 

They also tend to sell winning stocks too soon. 

Logic would suggest that holding onto winning stocks longer to potentially earn more money would make more sense. 

Likewise, selling losing stocks quickly to avoid greater loss would be wiser. 

Investors usually take the guaranteed gain, but take on greater risk to avoid a greater loss. 

That mindset can be dangerous in the world of investing! 

How To Avoid The Negative Effects Of Prospect Theory?

Consider playing a little trick on yourself. 

It can be useful to think of a gain as a series of smaller gains. 

You aren’t likely to view finding $50 in the same way as finding $10 five times. 

When it comes to gains, think of them as a series of smaller gains. 

Do the opposite with losses. 

A $50 loss is generally viewed as less painful than five $10 losses. 

Framing things in your mind this way will help to minimise the negative effects of the prospect theory. 

4. CONFIRMATION BIAS

This is the tendency to see or seek out information that fits in with existing beliefs, resulting in a self-reinforcing loop.

When you expect something to happen a certain way, you’re better at contorting any vagueness and uncertainty to fit the model you have in your head. 

For example, if you thought your romantic partner was losing interest in you, you would be more likely to interpret her actions as a slight or a sign of disinterest. But many times the actions are entirely neutral and don’t have any deeper meaning. 

How Does This Affect Investments?

An investor is more likely to have confidence in information that supports his beliefs. 

If he thinks a stock is a good buy, he’ll be more likely to interpret information in way that encourages him to buy it. 

This can be problematic because he’ll also tend to ignore information that discourages it. 

You shouldn’t be using information to prove your bias. 

Use all the information you have and make every attempt to leave your bias at the door. 

How To Avoid Confirmation Bias?

Confirmation bias is best avoided by finding an impartial second party. 

Being aware of confirmation bias is a good start, but that alone is usually not sufficient. 

OTHER BIASES

The topic of biases is fascinating as it explains some of our daily actions that we don’t realise.

But there are too many to discuss all of them. Here are some of the relatively common ones that also affect investment decisions:

  • Overreaction Bias
  • Availability Bias
  • Overconfidence Bias
  • Hindsight Bias
  • Mental Accounting
  • Gambler’s Fallacy

CONCLUSION

If you’re completely honest with yourself, you’ve probably been guilty of at least one of the irrational behaviours or decision-making processes that we’ve discussed. 

Source: Imgflip

But now you’re in a better position. 

You know what to look for and how to prevent these biases from affecting your investment decisions. 

Strive to keep your decision making rational and informed. 

Great investors make good decisions and are able to keep their thoughts and emotions under control. 

Becoming a better investor isn’t just about getting better at analysing stocks and allocating your investment dollars correctly. 

It’s also about exercising greater control over yourself. 

If you require any assistance or input, feel free to contact us here or email us at contact@avocadotoastfinance.sg.

CHEERS! 🥑🥑🥑

Disclaimer: This post is for your information only and does not constitute any form of financial advice, you may wish to seek advice from a financial consultant before making a commitment to purchase any product.