As an investor, it’s easy to think that the key to successful investing is a combination of analytical skills and market knowledge. However, even with a sound investment strategy in place, many investors often fall prey to common psychological mistakes that can hinder their investment performance. In this article, we’ll take a look at five common psychological mistakes investors make and explore how to avoid them.
Psychological mistake #1 Confirmation Bias
Confirmation bias is the tendency to seek out information that confirms our existing beliefs and ignore information that contradicts them. This can be a dangerous pitfall for investors, as it can lead us to ignore warning signs and invest in companies that may be overvalued or underperforming. For example, if we’ve already decided that a particular stock is a good investment, we may only seek out information that supports that view and ignore negative news or data.
Let’s say an investor has a bullish outlook on a particular stock. They may only seek out positive news articles or research reports that confirm their bullish thesis, while ignoring any negative news or research that could suggest the stock is overvalued or headed for a decline. This can lead the investor to hold onto the stock for too long, even as it begins to underperform or decline in value.
What can you do to avoid confirmation bias?
Seek out diverse sources of information – When researching a particular investment, make sure to seek out information from a variety of sources, including both bullish and bearish viewpoints. This can help provide a more complete picture of the investment and its potential risks and rewards.
Consider the opposite viewpoint – When considering an investment, take the time to consider the opposite viewpoint. Ask yourself, “What could go wrong with this investment?” You’ll be more aware of identifying potential risks or flaws in your investment thesis.
Psychological mistake #2 Overconfidence
Many investors believe they can consistently outperform the market and take on more risk than they should. This is defined as being overconfident which can lead to excessive trading or focus on a particular sector or stock.
Overconfidence can manifest itself in a variety of ways in investing. Some common examples include:
Failing to diversify: They believe that they can accurately predict the performance of individual stocks or sectors, leading them to concentrate their portfolios in a few select investments. This lack of diversification can lead to higher risk and lower returns.
Ignoring risk: They may believe that they are immune to risk or that they can handle more risk than they actually can. This can lead them to invest in highly speculative or volatile securities that may not be appropriate for their risk tolerance.
The key thing everyone should learn is that no one has accurately predicted share price correctly over and over again in the long term. One should focus on long-term goals and diversifying investments to reduce risk.
“The four most dangerous words in investing are: ‘this time it’s different.'” – Sir John Templeton
Psychological mistake #3 Loss Aversion
Loss aversion is the tendency to feel the pain of losses more acutely than the pleasure of gains. This can lead investors to hold onto losing investments for too long in the hope of recouping their losses, even when it’s clear that the investment is unlikely to recover.
How does loss aversion affect investing?
In the context of investing, loss aversion can manifest itself in a number of ways. For example, investors may be reluctant to sell losing investments, hoping that the market will eventually recover and they will be able to recoup their losses. This can lead to holding onto investments that are no longer viable, and missing out on opportunities for better returns.
Similarly, loss aversion can lead investors to be overly cautious in their investment decisions. They may avoid taking risks, even if the potential reward is high, for fear of losing money. This can result in missed opportunities for significant gains, as well as suboptimal portfolio performance.
Strategies to overcome loss aversion:
One way to mitigate the effects of loss aversion is to diversify your portfolio. By investing in a range of different assets, you can reduce the impact of any single loss. This can help to mitigate the fear of losing money and make it easier to stay the course when the market experiences volatility.
Another way to overcome loss aversion is to keep a long-term perspective. It can be helpful to remember that short-term losses are a normal part of investing, and that over the long-term, the market tends to trend upwards. By focusing on your long-term investment goals, you can avoid getting caught up in the day-to-day fluctuations of the market.
Ray Dalio on Loss Aversion:
“The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is more risky.”
Psychological mistake #4 Herd Mentality
Herd mentality is a strong cognitive force that even those who are aware may well fall prey to it. It’s the tendency to follow the crowd and do what everyone else is doing. This can lead investors to buy into popular investments without fully understanding the risks, or to sell off investments in a panic when others are doing the same.
Herd mentality is driven by a number of factors, including fear of missing out (FOMO), social proof, and the desire for validation. When investors see others making money on a particular stock, they may feel compelled to join in, for fear of missing out on the profits. Additionally, the fact that others are investing in a particular stock can act as social proof, making investors feel like they are making the right decision.
This is one of the most dangerous mistakes to make, yet many could fall into it as well.
When investors follow others, be it their friends or what they see on social media, they often end up buying at the peak of the market, when prices are high, and when Mr Market decides to react, chances are there will be a great sell-off that will result in prices going down fast.
Moreover, herd mentality can also create bubbles in the market. When investors are all investing in the same stock or asset class, the price can become inflated, creating a bubble that is destined to burst. When the bubble does burst, investors who followed the herd often suffer significant losses.
The first step in overcoming herd mentality is to recognize it. Investors should be aware of their own biases and tendencies, and question their own reasoning when making investment decisions. It is important to do your own research and analysis, and not rely solely on what others are doing.
Moreover, investors should have a well-diversified portfolio that is not overly concentrated in any one asset class or stock. This can help mitigate the risks of following the herd, as losses in one area can be offset by gains in another.
Peter Lynch on Herding:
“The herd instinct among forecasters makes sheep look like independent thinkers.”
Psychological mistake #5 Anchoring
Sometimes, investors rely too heavily on the first piece of information they receive when making decisions. This can lead them to fixate on the price they paid for a particular investment, or to hold onto outdated assumptions about a company or market.
One common example of anchoring in investing is when investors anchor their expectations to the initial stock price of a company. They may be reluctant to sell a stock that has fallen below its initial price, even if the company’s fundamentals have deteriorated and the stock is no longer a good investment.
Another example of anchoring in investing is when investors rely too heavily on historical data to make decisions about future performance. They may anchor their expectations to past performance and fail to recognize changes in the market or economy that could impact the stock’s future prospects.
So instead of relying on initial stock prices or historical data, investors should conduct their own research to determine the true value of a company. They should analyze the company’s financial statements, industry trends, and competitive landscape to make an informed decision about whether the stock is a good investment.
In this video below, I’ve managed to invite the great niece of Sir John templeton, Lauren C Templeton, to Singapore for a paid seminar. Here she shares the 5 common mistakes to avoid in investing.
Disclaimer
The above article is for educational purposes only. Under no circumstances does any information provided in the article represent a recommendation to buy, sell or hold any stocks/asset. In no event shall ViA or any Author be liable to any viewers, guests or third party for any damages of any kind arising out of the use of any content shared here including, without limitation, use of such content outside of its intended purpose of investor education, and any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages resulting from such unintended use.