Don’t get caught off guard.
Want to invest? Keep in mind this common psychological mistakes
We like to pat ourselves on the back and say that we are rational beings. We are…to a certain degree. Suddenly you get caught off guard and you see yourself making systematic errors that cost you dearly. And sadly, it then becomes too late to recover.
You’ve already invested badly. You’ve sold your stocks on the first signs of downfall. You thought that THAT particular stock to which you had grown so fond of, was going to recover and go up because…well, surely after so long of going down it has to change its course, right?
To clear things out, and not trip over the same rock twice (or god forbid thrice!), let’s see some of the common psychological mistakes while trading in the stock market.
Who doesn’t feel they can do a much better job at…[insert here any task]… than the guy next to you? We tend to presume on our abilities and that’s no good when you’re trying to outsmart the market and all the big players in it. First try focusing on not losing money, before trying to anything else. Anyway, so how do you see this overconfidence in investment?
- Too little diversification: you might put a lot of money in a local company but your money now depends on this company’s fortune. People think that they really know how that company works (overconfidence) so they put all their money in one “safe bet”. This can happen when people invest too much in the stock of the company they work for (e.g. auto industry employees in Detroit). It’s just too risky to put all your eggs in ONE basket.
- Frequent trading by non-professional investors: when you buy and sell the same stock on the same day you can be called a day trader. A study found that the gross profits of heavy day traders are not sufficiently large to cover their trading costs, so as a group more than 80% of them actually lose money . So even though they could trade at favorable prices, their money was sucked by transaction costs. Their overconfidence makes them invest more frequently without realizing that they’re actually losing money. And to put the cherry on top: while both genres earn poor returns, men perform worse than women .
Let’s say you’re entering into the stock market in the late ‘90s. You’ve seen other people getting on board and get some nice equity returns. You look at the S&P 500 Index Stock in 1997, an impressive 33% return. Then in 1998, 28.3% return, still great. “With this kind of profit I’ll get rich in no time”, you think to yourself so you start to invest in 1999. You’ve invested well and you’ve had a good profit, somewhere near the 20.9% return of the S&P 500 Index Stock.
So based on what you’ve seen from your friend’s experience and the historical market return from last year, you are sure this trend will continue. And you invest a lot more next year. Congratulations! You’ve entered a 3-year negative market return. Hang on for the ride.
Basically, you put too much weight on recent experience (those positive returns you saw earlier). You and a lot of people started believing that high equity returns were normal. And you expect that trend to continue. Be cautious and don’t fall for this bias in your stock trade reasoning.
People are slow to pick up on changes. They stick to their previous normality. They like the way things have normally been. Or at least they’ve become so accustomed to them that it will take some time to make changes, if any.
Let’s say the market has had two consecutive quarters of negative economic growth. Some would define this as the beginning of a recession. People might underreact because of the conservatism bias. They would hold on to stocks even if they lose 25%, 50% or more. And remember how much you need to recover from those numbers:
- If you lose 25% you need a 33% percent gain to break even.
- If you lose 50% you need a 100% gain to recover.
So your failure to act can cost you quite a lot. And on top of that when a new pattern emerges, people will fall into this new normal state. And thus the cycle repeats.
We all have some reference points in our minds (a.k.a. anchors) that we use while making a decision. Our assessment of a situation relies on previous data we’ve stored. That’s normal.
The problem lies in the type of information we take into account. As investors we might tend to focus on recent behavior or information (e.g. previous’ week stock price) and give less emphasis to longer time trends (e.g. bullish and bearish markets).
There are different types of anchors. People may rely on external data like public information (your mind is stuck with that so-called expert’s assessment of your favorite stock for instance) or it can be some internal data like a self-generated anchor (that real estate valuation of your home-made 10 years ago that you still use to compare prices, for example).
So the risk here is to use rapidly available information (info that’s very fresh in your mind), as the basis for decision making. There hasn’t been enough analysis and you take shortcuts to arrive to an easy answer. That’s very risky to your pocket.
When operating in the stock market we have to be aware of our own psyche failing us. No one is free from error of course, but the first step to reducing it is to know what’s going on in our minds. We have different biases that affect our ability to trade and make us eventually overreact or underreact.
Here’s a quick summary of the ones we talked about:
- Overconfidence: judging our skills too positively and thus making poor judgment calls.
- Representativeness: mistaking recent events for trends that you feel will last while avoiding new useful information.
- Conservatism: sticking to a sense of normality that reduces your ability to adapt to change.
- Anchoring: making decisions with unreliable points of reference that come easily to your mind (without further analysis).
These are just a few psychological mistakes. I suggest you take a good look at yourself in the mirror and try to find your blind spots. Be sincere with yourself and you’ll do better. Isn’t that what we all aim for? Even if it takes learning some tough things about yourself, let’s do something about it!
And remember, first things first…reduce your losses, and THEN go for the big wins.
Note: If you want to dig deeper, here’s a more comprehensive list of common mistakes and ways to avoid them.
 Barber, B. M., Lee, Y. T., Liu, Y. J., & Odean, T. (2004). Do individual day traders make money? Evidence from Taiwan. University of California, Berkeley, working paper.
 Barber, B. M., & Odean, T. (2001). Boys will be boys: Gender, overconfidence, and common stock investment. The quarterly journal of economics, 116(1), 261–292.
Ceren, U. Z. A. R., & AKKAYA, G. C. (2013). The mental and behavioral mistakes investors make. International journal of business and management studies, 5(1), 120–128.
Ritter, J. R. (2003). Behavioral finance. Pacific-Basin finance journal, 11(4), 429–437.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
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