This Action bias is at odds with the fact that ‘doing nothing’ is a core component of investing, which allows compounding to continue uninterrupted. It is important to take your emotions out of the decision-making process.įaced with uncertainty, humans instinctively want to take action in order to be seen to be controlling events and making an effort to influence a situation. Solution: Avoid the risk of being influenced by emotion by having a long-term investing plan, checklists for decision-making and strict buying and selling rules. Optimism and overconfidence can lead to unnecessary and reactive (and expensive) trading, excessive risk-taking and chasing returns. This inherent optimism can be dangerous because it implies that investors may think they have more control over events than they actually do (see Action Bias). Psychologists have found that people tend to underestimate the chances of negative things happening to them and overestimate the chances of positive things happening. Optimism and overconfidence (emotional trading is costly) It’s preferable to keep an open mind and accept that the strengths and weaknesses of a share will inevitably change over time. Solution: Anchoring is dangerous because it means having closely-held beliefs about a company or share, which can ultimately lead to falling in love with it. That is because it arguably causes post-earnings announcement drift, where prices creep higher as investors only slowly accept that an already high price deserves to move higher. The anchor becomes a reference point from which all other decisions are made.Īnchoring is such a powerful force that it’s been credited as a driver of price momentum in markets. Anchoring (over-emphasising certain information)Īnchoring is when decisions are made using too much emphasis on one (usually the first) piece of information. Here are some of the most challenging psychological flaws that affect investors, and ideas on how to avoid them: In the words of the Chinese military philosopher Sun Tzu, who wrote The Art of War: “If you know the enemy and know yourself, you need not fear the result of a hundred battles.” In order to avoid these missteps, what you need to do is know what they are, how they can manifest, and how to avoid them. Sudden sell-offs are not the only cause of psychological pain for investors, but they are an extreme example of moments when panic and volatility can lead us to poor choices. Often the reasons will be long forgotten, but you can be sure that emotions were running very high at the time. Look closely at the details of a long-term market chart like the one above, and you could pick out any number of times when equities sold off sharply. Investors have had to navigate a whole host of uncertain moments, some more serious than others. Rather than growth, talk now is about the prospect of recession.Įven though the years since the financial crisis in 2008/09 have been dominated by central bank stimulus, it hasn’t all been plain sailing for shares. With it came a major change in priorities for central banks and a series of sharp interest rate hikes. After more than a decade of apparently stable monetary conditions, inflation roared back up the agenda. The past 18 months in the stock market have asked some tough questions of investors. After that, I’ll explore some of the qualitative and quantitative features in shares that can break an investment from the start. In future articles, I’ll look at some of the external influences – including analyst forecasts, tips, news and internet bulletin boards – that can lead us astray. It starts with a tour of our own psychology and how it plays against us. This week marks the first article in a mini-series looking at some of the things you shouldn’t be doing as an investor, in order to get better results. But when you apply those emotions and behavioural traits to markets, it can end in a mess if you’re not paying attention. Millions of years of evolution has wired our instincts to protect us from harm. When it comes to making good decisions, psychologists have found that investing is a field where humans are surprisingly bad at doing the right thing. In the first of a multi-part series on avoiding investment mistakes, Ben looks at how our own emotions and behaviour can lead to poor decisions, and what we can do about it.
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