All in your head: Avoiding 5 mental traps in investing Behavioural science insights on avoiding investment psychology traps. In the last few years, behavioural economics – a once-marginal field that brings psychological insights to the world of economic behaviour – has really come into its own. There are now plenty of accessible books on the topic of how our normal psychological process can hamper our ability to invest successfully, books like Beyond Greed and Fear, Thinking Fast and Slow, and Predictably Irrational, all of which you should read. However, for those of you who were planning on just reading this article, I’ve taken the liberty of distilling out a few of the most interesting insights that this body of work has to offer the everyday investor. After all, being aware of these psychological traps is the first step in avoiding them. 1. Overconfidence Human beings have a strong tendency to overrate their own abilities. It’s called “self-enhancement,” we all think that we’re better-than-average drivers, that we’re better than average at our jobs, and that we’re better looking than we really are. This self-enhancement bleeds over into investing; most investors think that they’re more likely to pick winning stocks than their peers . Obviously, this isn’t true: not everyone can be better than everyone else. The danger is that if you believe this, you may take unnecessary risks. The key to avoiding this trap is to remind yourself that you are probably only an average investor. I know, I know, you think you’re a good judge of your own abilities – most people believe that they’re better at self-assessment than others – but trust me. You’re probably just about average. 2. Loss aversion and sunk costs Human beings tend to fear loss more than they desire gain. Studies show that people will sell winning stocks to “take profits,” but hold on to losers in the hope that things will turn around. Because we fear that our winners could turn to losers, we sell them, and because we’ve already lost on the losers, we fear losing more and won’t sell. Associated with this is the way we perceive sunk costs – costs that we’ve already incurred and cannot recover. We tend to include those costs as a factor in decisions, as in “Well, I’ve already lost X rands, I should hold on to see if I can recover them”, instead of taking a rational approach and simply assessing what our future costs or gains are likely to be. Be aware of this, and when making buy and sell decisions, be sure that you’re thinking rationally about losses and gains. You can also use stop-loss orders to discipline yourself to get rid of bad eggs. 3. Anchoring This is an interesting cognitive bias. Basically, we tend to give undue to weight to the first piece of information we learn about something, and to “anchor” our expectations to it. For example, let’s say the first thing you learn about a company is that its earnings are up 50%. This creates a positive bias, and when you get more information, for example, if you find out that the company’s share price has fallen, you’ll tend to anchor on the first piece of information and think “It must be undervalued.” You could be wrong, perhaps they just lost a big customer and earnings are set to fall, but your anchor influences your thinking. The way to avoid this, obviously, is to gather as much information as you can when making a stock purchasing or sale decision, and make sure that you’re weighting each piece of information equally. 4. Confirmation bias Once we’ve made a decision, say purchased stock A, we begin to suffer from confirmation bias. When we read a news article about A, we tend to overrate the confirming information that says that A is a good buy, and discount the disconfirming information. We even seek out confirming information – we’ll read an article titled “Why A is the next big thing” and skip one called “Trouble at A?” A good way to overcome this is to make a special effort to seek out some bad news for every piece of good news you look at. The idea is to make sure you get the whole picture, and don’t allow your biases to prevent you from learning something you need to know. 5. Herding This is probably what causes stock market booms and busts – our tendency to do what everyone else is doing. When investors begin to buy, say, tech stocks, other investors see the prices rising, jump on-board and buy tech. The prices keep rising, and more and more people join the herd in buying. Eventually, the herd panics (perhaps loss aversion kicks in), and there’s a sell-off. The best you can do here is to be aware of this tendency. Some people think they can time herd behaviour and benefit from it, but remember overconfidence! Best to always base your investment decisions on a solid, rational framework (accounting for loss aversion, confirmation bias, and anchoring), and never buy something just because it’s “hot.”
Posted on: Sat, 08 Jun 2013 09:30:58 +0000
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