“Buy low, sell high” – the goal of investing seems so easy. But getting there is very hard. Before investors can become successful, they have to master themselves and their own psychology. Otherwise, they will be their own worst enemy.
Academics have researched investor psychology for decades. The discipline of behavioral finance has identified a number of psychological trading traps that keep investors from becoming profitable. Here are the five biggest psychological traps for investors and how to overcome them.
1. Familiarity/Home bias
“I know this industry,” or “I know this company, I don’t have to do additional research.” This is the core fallacy behind this bias. This trap basically says that the more we feel that we are familiar with a certain industry or company, the less of research we feel is necessary to make an investment.
Another way in which this trap shows itself is the “home bias” that leads investors to only buy shares of companies in their own home country, leading to an overconcentration of shares in one country (also known as a lack of geographic diversification).
To overcome this bias, you first have to become aware of it. You then need to acknowledge that you need to do additional research in the industry (because you actually don’t know it all!). Build your investment thesis with external reports and analysis and see if you’re still as familiar as you felt before.
2. Sunk cost trap
The more you have already invested into a project or thesis, the more you feel obliged to stay consistent to that investment. In economic theory, this is what is known as sunk cost – an investment you cannot make undone.
Social psychologist Robert Cialdini has long shown that human beings have a strong desire to remain consistent with their past behavior, commitments and decisions. While this is well-intentioned, it can be damaging in the investment world. If you invested into the wrong company or project, you should get out of it as soon as possible. Once you recognize something was a mistake, the sooner you correct it, the better. Don’t worry about being inconsistent but learning from your mistakes and doing better in the future.
3. Confirmation trap
This psychological trap describes the tendency for human beings to only look for information that confirms and is consistent with what we already believe. For example, if you believe the Tesla stocks are still highly undervalued, you will tend to focus on headlines, reports and analysis that support that thesis.
The confirmation bias is accompanied by blindness and ignorance. You will discredit, filter or simply overlook such experts, analyses and commentaries that question your bullish thesis for Tesla stock.
How do you overcome the strap? First of all, again, by becoming aware and acknowledging that you most likely are suffering from this bias. Then, in the next step, you need to actually look for information that challenges your investment thesis. Eventually, you will come up with a list of pros and cons that you contrast with each other. Take an honest and detailed look at the arguments gathered. In light of this new information, would you make a different investment decision now? Asking yourself this question is what psychologists call “zero-based thinking”.
4. Extrapolation bias
The term extrapolation basically means to take existing trends in known data and infer an estimation for future data. Put more simply, it describes the human tendency to believe that current trends are bound to continue this way in the future. This is particularly dangerous in the case of bullish market phases, sometimes referred to as exuberance.
This psychological trading trap causes many retail investors to buy at largely overvalued prices, often just days before a major market correction or decline sets in. Obviously, past performance is no indicator for future performance. Markets go up and down, every bull cycle comes to an end and may be followed by sideways movement or a bear market.
Case in point: Investors that bought stocks at the height of the Dotcom bubble in 1999 had to wait for 11 years (until 2010) to recover their losses. It’s a horrendous price to pay, and it gets even worse when you apply the concept of opportunity cost.
How to avoid this trap? Check for valuation metrics like a price-to-earnings ratio or free cash flow or price-to-book ratio if you’re investing in stocks. Take a closer look at the price chart of the asset. If the price has been going up for weeks or months, the market is probably overheated and bound for correction.
On the other hand, if the price is way below previous all-time highs, the asset may actually be undervalued and a trend reversal could be around the corner.
5. Loss aversion
Psychological studies have shown that experiencing loss is more painful and consequential in the human brain than gaining pleasure. Put into the context of investing, this means that investors will tend to do more to avoid losing 1 EUR then they will do to gain 1 EUR.
Effectively, the psychological trap leads to panic selling when a major sell-off occurs, causing investors to sell at the worst possible time instead of waiting and sitting out for prizes to recover (even if this could take months or sometimes years). Remember you only really lost it if you sell the assets – otherwise it is unrealized losses!
You overcome the loss aversion trap by realizing that in the long-term the markets tend to always go up. Understand that panic selling is the worst thing you can do because you sell at the worst possible time. It technically doesn’t matter “how many percent you are down”, as long as you’re not selling you have not realized a loss.
If your portfolio is down by a significant amount, you should take a step back to escape the emotion. Once you can take a calmer, more objective look at your portfolio, you should try to evaluate if the losses with each asset are temporary or maybe more long-term in duration. Always keep in mind what investor legend Warren Buffett said about the financial markets being “a device for transferring money from the impatient to the patient”.
Success in investing comes not just from picking the right investments, it comes from mastering our own psychology. Investors must become aware of and learn how to overcome the five big psychological traps in order not to self-sabotage their own success.
- Overcome the familiarity bias by exposing yourself to opposing views and investing the necessary research and due diligence.
- Overcome the sunk cost trap by practicing zero-based thinking, asking yourself if you would hold or end placed investments.
- Overcome the confirmation bias by consciously seeking out and researching information challenging or opposing your existing investment thesis.
- Overcome the extrapolation trapped by discerning past from future performance and judging current price levels based on previous all-time highs.
- Overcome the loss aversion trap by realizing that panic selling is the worst possible move. Take a step back, come back with a fresh mind and reevaluate your investments one by one.
This is not financial advice. Mentioning coins and tokens is not a recommendation to buy, sell, or participate in the associated network. We would like to encourage you to do your own research and invest at your own risk.