The Psychology of Investing
The Psychology of Investing
Human psychology is a dangerous thing, and there are some alarmingly standard mistakes that people make again and again. It is very easy in the heat of the moment, or when subject to stress or temptation, to fall into one of these mind traps. The wrong perceptions, self-delusion, frantically trying to avoid realizing losses, desperately seeking the comfort of other victims, shutting out reality and more can all cost you dearly.
However, if we are aware of the nature of these traps and always try be honest and realistic with ourselves we can avoid many of them and go on to manage our pensions effectively and profitably. I have drawn the following traps and examples from a variety of sources; US Personal Finance Magazine Kiplinger, whose Risk Quiz I can heartily recommend as a bit of educational fun; a great Telegraph article on The Psychology of Investment by Emma Wall; and an Investopedia article on avoiding common investing pscychology traps by Brian Bloch.
Of course, if you think you are prone to suffering from any of these traps it is always a good idea to seek advice from a competent and knowledgeable adviser who will bring you back to reality before it is too late.
So, on with the traps and brain tricks:
Firstly, there is the so-called anchoring trap, which refers to an over-reliance on what one originally thinks. For instance, if you think of a certain company as successful, you may be too confident that its stocks are a good bet. This preconception may be totally incorrect in the prevailing situation or at some point in the future. For example, the German consumer electronics company Grundig, which was the major European supplier in the 1970s, was wiped out in the 1980s by competition from Japan. Those trapped in the perception that Grundig was there to stay, lost a lot of money.
In order to avoid this trap, you need to remain flexible in your thinking, and open to new sources of information and the reality that any company can be here today and gone tomorrow. Any manager can disappear too, for that matter.
The sunk cost trap is just as dangerous. This is about psychologically (but not in reality) protecting your previous choices or decisions, which is often disastrous for your investments. It is truly hard to take a loss and/or accept that you made the wrong choices or allowed someone else to make them for you. But if your investment is no good, or sinking fast, the sooner you get out of it and into something more promising, the better.
If you clung to stocks that you bought in 1999 at the height of the dot.com boom, you would have had to wait a decade to break even, and that is for non-hi-tech stocks. It’s far better not to cling to the sunk cost and to get into other assets classes that are moving up fast. Emotional commitment to bad investments just makes things worse.
Linked to the above is the confirmation trap. People often seek out others who have made, and are still making, the same mistake. Make sure you get objective advice from fresh sources, rather than phoning up the person who gave you the bad advice in the first place. If you find yourself saying something like, “our stocks have dropped by 30%, but it’s surely best just to hang onto them, isn’t it?” – you are seeking confirmation from some other unfortunate in the same situation. You can comfort each other in the short run, but it’s just self-delusion. Ignoring facts that puncture a “too-good-to-be-true” story is known as confirmation bias—we only look for things that support what we want to believe.
Situational blindness can exacerbate the situation. Even people who are not specifically seeking confirmation often just shut out the prevailing market realities in order to do nothing and postpone the evil day when the losses just have to be confronted. If you know deep down that there is a problem with your investments, such as a major scandal at the company or market warnings, but you read everything in the newspaper apart from the financial pages, you are probably suffering from this blinder effect. I know that I suffer from this one – I check the perfomance of my portfolio daily when markets are rising but I let the daily check slip when markets are heading down or have suffered a correction – just the time I should be checking and taking any remedial action necessary.
The relativity trap is also there waiting to lead you astray. Everyone has a different psychological make-up, combined with a unique set of circumstances extending to work, family, career prospects and likely inheritances. This means that although you need to be aware of what others are doing and saying, their situation and views are not necessarily relevant outside their own context.
Be aware, but beware too! You must invest for yourself and only in your own context. Your friends may have both the money and the risk-friendliness to speculate in pork belly futures (as in the movie “Trading Places”), but if you are looking for secur eincome in retirement, this is probably not for you.
For some people, the superiority trap is extremely dangerous. A lot of investors think they know better than the experts or than the market. Just being well educated and/or clever does not mean you don’t need good independent advice and, even more so, it does not mean you can outwit the pros and a complex system of markets. Many investors have lost a fortune through being convinced that they were better than the rest. Furthermore, these people are easy prey for some of the other traps mentioned above.
In this trap you often struggle to imagine a scenario which is radically different from the current status quo. If you have owned a share or fund which has hit a high and then fallen back significantly, it can be difficult to acknowledge that you are unlikely to see the stock reach that price again in the short to medium term, if ever. This requires you to reassess your data and to accept that you have made a mistake.
So attachment bias prevents you from making an impartial decision and means people tend to discount evidence which contradicts their opinion. It is one of the contributory factors to creating a bubble, and explains why the sceptics are often sidelined or ignored even when the bubble looks ready to pop.
When markets rise, investors pile in. Then as portfolios swell, we start to feel a collective buzz courtesy of dopamine, a feel-good chemical that the brain produces at the mere thought of making money. The more dopamine is produced, the more primitive our decision-making becomes, making it harder to think logically.
When investments or markets go up, and do so consistently for a long period of time, we start seeing them as less risky. So we look around for riskier investments. Clever people lost their sense of caution because they had known nothing but gains for several years.
The Bottom Line
Barclays Investors is one investment company that has taken this knowledge of psychology and uses it in advising their clients. Rather than ask some rather vague questions about risk appetite, the firm invites new investors to complete a Financial Personality Assessment. The test assesses five major personality traits: openness, conscientiousness, extroversion, agreeableness and emotional stability. “We are focusing principally on the ‘conscientiousness’ variant to ascertain how much or how little the client wishes to engage in the advice process and to ensure that we deliver the correct amount and type of information in order for them to make a decision,” said director Marcus Carlton.
“We anticipate that the client’s degree of conscientiousness will inform us if they are rash decision makers or if they make more studied decisions, and the profiler will also look at emotional stability in order to analyse likely reaction to unexpected outcomes – for example severe market volatility – so that we can protect clients and manage their expectations better.”
You do not need a psychometric test to take advantage of this psychology. Mr Davies said investors should exercise self-knowledge and put in place a set of rules for investing.
“Most of us can help break our emotional investing habits by setting a framework in place in times of calm to be prepared for times of turbulence. You can bet those investors who are taking advantage of value stocks now will have planned their response to these situations. They will be informed and have engaged with markets for a while,” said Mr Davies.
So there you have it – much of investing is about managing one’s own psychology and having the courage to question the behaviour of the crowd. It is much harder to do than it sounds, but is a lesson best learned early on.