Psychological traps to avoid when investing
Buy. Hold. Sell. Whether you’re new to the stock market or are fairly familiar with trading, at some point, you might need to make a tough call on your investments. Are your decisions guided by facts, or are there psychological traps that you could be blind to? Here are four common ones you should know about.
Trap #1: Sunk-cost fallacy
Humans have an emotional attachment to people, objects and memories. The attachment continues even when things go wrong, which is what happens when you stay in a bad relationship or a job that makes you unhappy. As Stephen Dubner from Freakonomics puts it, “The sunk-cost fallacy is when you tell yourself that you can’t quit because of all that time or money you spent.” Sounds familiar?
While you may think that your decisions are always rational and based on the future value of the investment, the truth is that your decisions may be tainted by emotions.
How to recognise the sunk-cost trap:
- Those first shares you bought of Company X were stellar performers. Over time, however, the numbers have been on a downward trend. But because it previously gave you an amazing bull’s run, you find it hard to accept that a stock that you handpicked and made a profit from might have soured.
- You bought an apartment for investment purposes. You’ve been renting it out and have diligently kept it in good condition. Perhaps you’ve entertained thoughts of moving into it in later years. One day, someone makes you a profitable offer, but when you think of all the effort and money you’ve put in to it, you can’t bring yourself to part with it.
The antidote: Knowing when to quit can be a good thing. Whatever positive results you had in the past won’t guarantee future performance. Make your decision based solely on information you have in the present.
Trap #2: Overconfidence
You’ve been on a winning streak in your investments and each uptick in the stocks’ prices convinces you of your Midas touch. Have you become overconfident? Do you really always make the right choices and have laser-sharp predictions? Your emotional high may have caused you to remember your successes but to gloss over previous investment errors. Overconfidence is a persistent over-evaluation of your investment decisions.
How to recognise the overconfidence trap:
- You only buy one class of stocks because you believe you understand it well and don’t see a need for diversification. You think diversification is only for those who cannot see the future.
- You continue buying a stock even though others label the investment as ‘risky’, because you don’t believe you can be wrong.
- You keep on trading and do scant research, believing that you can successfully time the market.
The antidote: Believing in something doesn’t necessarily make it true. Get a second opinion when it comes to transactions involving large sums of money. Adopt a decision-making process that follows a series of logical steps, such as a checklist of what to look for in an investment, and a list of possible outcomes.
Trap #3: Confirmation bias
Confirmation bias happens when you seek information to support an existing preference, largely discounting any opposing evidence. Imagine a personal filter button defaulted to "That sounds right". Warren Buffett, the super-investor, observed: "What the human being is best at doing, is interpreting all new information so that their prior conclusions remain intact". In other words, what you see(k) is what you expect to see.
How to recognise the confirmation bias trap:
- Your financial advisor introduces you to a bond. You think you understand it, but still seek your family’s opinion before diving in. You take in your brother’s point because he made money from bonds previously, but give less weight to your partner’s equally well-researched but contrarian opinion, dismissing it as unsubstantiated.
The antidote: Check if you are truly examining all evidence with equal rigour. Be honest about any inherent biases you may have, and if you are looking for information to help with your decision-making or merely to justify what you already favour. Avoid asking leading questions when seeking advice.
Trap #4: Framing
Sometimes, we instinctively frame questions in a certain way to get favourable answers. For example, asking, “What are your thoughts on XYZ Ltd?” will yield a different answer from “Don’t you think XYZ Ltd is a good investment given its recent share price increase?” Framing a question is one of the most dangerous traps because how you word your questions can have an impact on the answer and advice you receive.
How to recognise the framing trap:
- You find yourself asking questions with only binary answers. These only yield a yes or no answer, without the details needed to address a complex topic.
- On Google, you repeatedly search for “XYZ stock profit” or “XYZ stock increase”, instead of “XYZ stock performance”.
- You’re caught in a downswing of the market. Instead of finding alternative solutions, you keep harping on why the investment went awry.
The antidote: Reframe your questions and pose them to yourself and others in neutral ways. Always ask why and don’t take a flat yes or no answer.
Disclaimers and Important Notice
This article is meant for information only and should not be relied upon as financial advice. Before making any decision to buy, sell or hold any investment or insurance product, you should seek advice from a financial adviser regarding its suitability.