If you think investing is solely about numbers, it’s time to think again. Investor psychology – that is, the mental and emotional factors that impact the way we as humans make investment decisions – can also have a significant impact on your relative portfolio success. Looking beyond statistics and market trends and focusing on investor psychology is a helpful way to avoid inherent biases, clarify your strategy, and make sure you’re acting in your own best interests. Below, we’ll review six psychological pitfalls many investors face and what you can do to avoid them.
Investor Psychology Trap #1: Anchoring Bias
Anchoring refers to a person’s internal pull to believe what they originally believed. For example, let’s say you had a positive personal experience that leads you to believe Company X should be profitable. That innate bias can lead you to be a bit too confident that its stock is a good investment, even if the numbers say otherwise.
If you want to avoid this investor psychology pitfall, the key is remaining flexible and open to new data. Taking the long view and recognizing that nothing is permanent is also helpful. Keeping those concepts in mind as you make decisions about your portfolio can help you remain savvy in the face of changing dynamics.
Investor Psychology Trap #2: Sunk Cost
Sunk cost refers to an investor psychology phenomenon in which investors mentally protect their previous decisions. As humans, our brains sometimes refuse to accept that our past decisions weren’t actually good moves to make. Because of this, investors have a tendency to cling to their sunk costs at their own peril.
It can be difficult to admit our own fallibility, yes. However, the sooner you get out of a bad decision, the better.
Investor Psychology Trap #3: Confirmation Bias
Do you have a habit of seeking out people who agree with you or information that supports decisions you already made? If so, you may be susceptible to confirmation bias. In investing, people have a tendency to look for others who have made or are still making the same mistake. It’s also tempting to ignore certain information in favor of alternate information that confirms our own beliefs and decisions. Psychologically, it helps us feel justified and confident, even if the decision we’re hoping to reinforce isn’t a good one.
This is an easy investor psychology trap to fall prey to, mainly because you can find so many varied opinions on the internet or in the financial media. If you think it’s impacting your decisions, the best way to dig yourself out is to take a step back and seek out fresh perspectives and unbiased information.
Investor Psychology Trap #4: Blindness
The stock market can be a volatile place, and sometimes it feels easier to just cover your eyes and ignore what’s happening! Of course, if you do this, you have fallen into the blindness trap. If you’ve shut out what’s actually happening in the markets just to postpone something undesirable or avoid making a decision, you’re only hurting yourself in the long run.
The blindness trap is very common, and it can be quite powerful, too. From an investor psychology perspective, it takes on more weight as consequences increase. Say there are some giant red flags with an investment you’ve made, or you’ve caught wind of a company scandal, yet you’re still not comfortable with making a decision to sell. Giving in to blindness and postponing facing reality only causes more harm to your bottom line in the end. Force yourself to face facts and adjust your strategy accordingly.
Investor Psychology Trap #5: Relativity
As already mentioned, the rise of the internet and the popularity of financial media means you can easily access different opinions. There are many conflicting schools of thought about investing, and they can feel overwhelming at times. It’s a natural human instinct to want to compare your choices or situations with others, but if you do too much of that, it’s considered the relativity trap. This means placing too much importance on others’ decisions without also considering their unique set of circumstances.
It’s important to remember that comparison is unhealthy in most areas of life, and it’s certainly true of investing. Your portfolio and investment strategies are very personal pursuits. Your risk tolerance, interests, and goals are your own, and it’s okay if they look different from everyone else’s.
Investor Psychology Trap #6: Pseudo-Certainty
This investor psychology concept is all about assessing and perceiving risk. Investors tend to avoid risk just at the moment when their portfolios can handle a bit more—when they’re flourishing. In contrast, many investors tend to seek more and more risk when it looks like they’re headed toward a loss. This happens largely because of our innate psychological pull toward winning it all back. Our human brains think that if we raise the stakes, we have a chance to reclaim our losses.
If you feel yourself giving in to this internal pull, remember that you don’t actually have a chance to create any more capital – and that the risk of losing more is significant.
Getting Intentional About Your Own Investor Psychology
We are all human, which means we are all susceptible to the investor psychology traps mentioned above. This doesn’t mean you’re a bad investor and, in fact, you may be experiencing a lot of investing success. However, it’s important to be intentional about not falling into these investor psychology traps, and the first step is being aware of them.
Working with a financial advisor is a valuable way to guard yourself against these traps, too. Having an experienced, knowledgeable professional in your corner can counteract innate biases and lead to less emotional, more fact-based investment decisions. If you’d like to speak with a member of the Attleboro Wealth Management team to learn more, schedule a discovery call today.