Investing isn’t only a financial challenge; it’s also psychological. Acknowledging potential investor psychology pitfalls will enable you to make more rational and data-driven decisions when making investments.
Regret avoidance is one of the more prevalent investor psychology traps; this article explores three such traps and provides strategies to overcome them:.
Loss Aversion
Loss aversion is a cognitive bias that influences our decision-making, leading people to weigh losses more heavily than gains, even when their likelihood is very small.
Investors with a stronger tendency towards loss aversion tend to be overly conservative, opting out of risky investments and missing out on potential gains. Furthermore, they may cling onto losing investments too long in the hope that something might turn around; this phenomenon is known as the sunk cost fallacy.
Kahneman and Tversky discovered that people ascribed irrationally high values to things they already owned, making their loss painfully more felt than expected – this finding formed the basis of what came to be known as the Endowment Effect.
Overcoming bias can be challenging, but there are ways you can minimise its effect. Being aware of various biases and how they influence investment decisions is the first step; having clear financial goals and plans will enable more rational investment choices during market fluctuations rather than being driven by fear of loss.
Confirmation Bias
Confirmation bias refers to people’s tendency to seek information that supports their existing beliefs or ideas, instead of challenging or changing them. People engaging in confirmation bias will tend to search and interpret new data selectively, disregarding or disregarding facts that challenge or contradict their preconceptions; moreover they tend to remember details supporting their preconceived notions rather than forgetting those which don’t align with them.
Researchers suggest that confirmation bias may serve an essential function by decreasing mental conflict (or cognitive dissonance), experienced when someone holds two opposing viewpoints. Another theory suggests it allows individuals to feel more secure about their beliefs, thus decreasing information processing costs.
To avoid falling into this common pitfall, aim for diversity of perspectives and structured processes when making decisions. Seek out experts willing to challenge your assumptions and beliefs and incorporate accountability and peer review to encourage critical thinking.
Herd Mentality
Herd Mentality refers to a tendency of following the herd rather than thinking and acting independently, often due to fear, greed or lack of confidence in oneself or social pressure and fitting into groups. Signs of Herd Mentality may include following investment trends blindly, joining bandwagons or fads without researching thoroughly enough, or panic buying.
Herd Mentality was designed with careful thought by its creators as an engaging question and effective teaching tool about herd mentality. With simple black-and-white rules and the need to match what the majority of players said – plus the threat of earning the Pink Cow of Shame! – players remained engaged and focused. Some versions even incorporate dice to alter scoring or add an element of fun (please consult individual games for specific die mechanics). By playing Herd Mentality you can begin understanding and overcoming psychological traps when investing money!
Illusion of Control
Illusion of Control can cause investors and analysts to believe they have more influence than they actually do over their analyses or investments, leading them to overtrade or concentrate their portfolios, leading to suboptimal investment returns and thus leading to overtrading and/or portfolio concentration. This cognitive bias can cause investors to engage in overtrading or portfolio concentration strategies which in turn result in subpar returns for investors.
One way to reduce illusion of control is to remind individuals they cannot predict the future, even with all available information. Another approach might be encouraging participants to use different methodologies when making predictions, such as estimating the probability of an event happening as a result of some action (Matute, Vadillo & Blanco 2013).
Individuals can help mitigate bias by seeking diverse perspectives and advice from experts in finance and investing. Doing so may reduce reliance on their beliefs and assumptions alone and prevent making risky decisions without sound principles as foundation.