There are so many ways that your own psychology is against you like loss aversion, sunk cost fallacy, anchoring, and much more. You are your own worst enemy and by understanding this you can invest smarter.
This is where a lot of this is explained and it is an amazing piece of material every investor should read: https://www.investopedia.com/terms/b/behavioralfinance.asp
It’s important before we start to level set what we are talking about. Fundamental analysis of assets is where you look at the financials of a company within the context of its industry and has little to do with psychology.
When we are talking about technical analysis which focuses on trends, patterns, and other indicators, market psychology is a large component of this, and this is what we are discussing today. Most investors are not investing based on the numbers and instead focus more superficial factors, namely their own emotions.
There is so much going against you so if you think the odds are in your favor, refer to this to ground you and help you invest more rationally.
- Sunk Cost Fallacy – This is when you sink time, energy, money, or value or some kind into an asset. Whether this is a relationship or something you’ve invested in, most people tend to be rationalize investing more into this asset because they have invested so much into it, that hopefully their investments and efforts will eventually pay off so instead of cutting their losses, they double down. For example, similar to loss aversion, you might double down on your investment once it’s lost half of its value in hope to gain that money back when it goes up.
- Mental Accounting Behaviors – People value money differently and typically do so based on subjective criteria that has detrimental results. An example of this is when someone receives a tax return and treats it as found money to do whatever with versus including it in their normal budget or funding a low-interest savings account while paying down a high interest debt. To avoid this, treat all money as fungible. I regularly hear people say things like “Oh well it’s just $60,” or “I can make that back in a day,” etc. People come up with reasons why this one time, the money you are using is not important or valued the same as other money. All money should be treated equal and important as it will all affect your overall wealth. If you act like money doesn’t matter, that mentality will negatively affect your financial outlook and likely lead you to act irresponsibly.
- Over-Reacting & Under-Reacting – This is an emotional response to market where you either over or under react. For example, your cryptocurrency goes down 5% which isn’t abnormal and so you overreact and sell everything.
- Irrational Exuberance Trap – This is when investors believe the future can be determined exactly by the past and act as if there is no uncertainty in the market.
- Pseudo-Certainty Trap – Investors are more likely to take on additional unnecessary risk when their portfolio is performing poorly and trending down and less likely to risk they could handle when their portfolio is performing well and trending up.
- Blindness Trap – It’s essentially the opposite of confirmation bias where you avoid new information or simply bad information even if you know it’s true and are blind.
- Casino Mentality – If you come into the market believing it’s like a casino where you could lose everything or make a ton of money and you’re willing to take good and bad bets, then you are already setting up for failure. Gambling by definition is wagering money with no skill with an expected negative return while investing is utilizing money to continue growing wealth in the future with an expected positive return.
- Time-Tested Theory – Money flow analysis suggests that a large portion of market participants buy at the top and sell at the bottom. Also, when markets are hitting peaks or valleys, buying or selling are at their highest.
- Limited Attention Span (Bounded Rationality) – You will make decisions based on the limited knowledge you can collect to make the most satisfactory decision, not the most efficient.
- Trend Chasing – The University of California study found investors who weighted decisions on past performance had the poorest performing portfolios. We can easily detect patterns and often when we find them, we believe in their validity. Often these patterns are already priced in or not as impactful as we believe.
- Loss-Aversion/Fear of Regret/Prospect Theory – This is one of the most important behaviors to understand. It’s where you place more emphasis on the concern for losses than the pleasure from market gains. For example, you may be more upset about losing $100 than you are happy about gaining $500. To avoid losing, you may risk even more money on a bad investment. Research shows that traders were 1.5 to 2 times more likely to sell a winning position too early and a losing position too late.
The prospect theory says that investors value gains and losses differently, placing more weight on perceived gains versus perceived losses. An investor presented with a choice, both equal, will choose the one presented in terms of potential gains. - Confirmation Bias – You are more likely to agree with information that confirms your beliefs and seek it out even if it’s flawed.
- Familiarity Bias – You tend to invest in things you know or are familiar with. This can actually be really good, but it may also lead you to be under diversified which is bad.
- Anchoring Behaviors – Having a bias towards an irrational or arbitrary benchmark figure. For example, you decide that you won’t sell until the price reaches $1000, because it’s a nice clean and even number when it’s unlikely the price will go that high. In everyday life this is seen at grocery store sales where the smaller item is on sale, yet the larger bulk item not on sale it still sold at a better price per unit. Anchoring yourself to the idea of the sale would trick you into getting a worse value when you though you were getting a better deal.
- Social Factors – Social relations play a big role. In a study, it was found that when making decisions on behalf of those you are close to, you invest with 1/3 less risk and even more so with investments accounts with pro-saving labels like “retirement” or “college fund.”
- Self-Enhancement – Similar to hot hand fallacy and self-attribution, you tend to take more credit for your successes than to luck, other people, and other variables that lead to your success.
- Experiential (Recency/Availability) Bias – This is the bias where people place priority on recent events or new information. They may also believe this event is likely to reoccur.
- Relativity Trap – A relativity trap is the behavior or bias that leads you to make an irrational decision.
- Herd Behavior – People tend to do what everyone else is doing and have fear of missing out on those perceived opportunities.
- Emotional Gap – Making decisions based on extreme emotions leading to irrational choices.
- Hot Hand Fallacy – An old gambling fallacy related to one thinking that because they’ve had a streak of success, they will continue to be successful. This is very common during bullish market runs for new traders.
- Positive Feedback – Pattern of behavior where the end result reinforces the initial act. You invest in a risky asset or even a scam early on and then make a lot of money and believe that therefore that is a good strategy to continue to follow.
- Over-Confidence/Self-Attribution – You tend to make choices based on overconfidence in your own knowledge or skill. This is typical when someone has some a bit more specific knowledge about a subject and suffer from the Dunning Kruger effect of believing they know a lot after just scratching the surface. These investors tend to lose a lot of their profits to trading fees from unnecessary trading.
According to Investopedia, the 2 best approaches to avoiding emotional investing are diversification and dollar-cost averaging. This is exactly what I’ve always done and recommended to lower risk exposure and because dollar-cost averaging has been proven to return the best profits over time.
Also, if you’re interested in fallacies and the ways our emotions and thinking can mess us up, I highly recommend learning about all logical fallacies and biases. I used to do a weekly post summarizing 5 fallacies and did something like 20 posts in the past. I think it’s really beneficial to understand and internalize these.
In a perfect world, the rational and logical investor would believe in the efficient market hypothesis (EMH). This means that all stock prices are valued accurately based on the information available. Unfortunately, biases, behaviors, and more get in the way and we end up with the irrational market we have today. If anything, the EMH is a guide for what assets should strive to be and while the market can be irrational, you can minimize risk in many ways.
I think the most effective and simplest way to beat out all the emotional fallacies, biases, and behaviors that negatively affect your finances is to always ask the question “What makes me special?” For example, you want to start day trading and look at the statistics that most people fail, so ask yourself, “What makes me special?” You should almost always come to the conclusion that you’re not special and that you are just as likely to fail as anyone else. This isn’t to discourage you, it’s to keep you rational and level headed with your finances so you don’t lose money.
How big of a part does our psychology play in investing? Is investing more about algorithms or human emotion? Is behavioral finance the key to success? Let me know what you think about this in the comments below and don’t forget to subscribe!
https://www.toptal.com/finance/financial-analysts/investor-psychology-behavioral-biases
http://oliverslearning.com/pdfs/psyinv/psychology_of_investing.pdf
https://www.merriman.com/psychology-of-investing/
*Disclaimer: This is not financial advice and is purely for entertainment purposes. What you see, hear, or read is my personal opinion, and any statements made are based on my views and should not be misconstrued as fact. My crypto portfolio may or may not be simulated*
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