20 psychological traps to watch out for when investing
Warren Buffett recognised that emotional management is key to being a good investor, and said that, “The greatest enemies of equity investors are expenses and emotions.”
Catching yourself falling into common investing psychological traps can be helpful in guiding your actions throughout the investment journey. Out of the 20 pitfalls below, how many are you guilty of?
1. Anchoring Bias
You strongly believe in a piece of information given and it is difficult to change your mind with new information afterwards.
2. Availability Bias
You recall things that were more frequently presented by the media easily and quickly. As such, when sourcing for investment instruments, you are sometimes unconsciously biased towards these products.
3. Confirmation Bias
You neglect due dilligence and instead, seek information that favours your current hypotheses. For example, if you believe that a particular blue chip stock will rebound following some announcements of a divestment, you will start scouring for news that support your views. Upon finding an article that is aligned with your views, you tend to stop searching for more information. When presented with an opposing view, however, you ignore it or continue searching for news that confirms your original opinion.
4. Disposition Effect
This refers to the tendency to buy more when a stock falls, and sell when it is rising. You often end up wondering why the stock price is dropping far longer than you expect. Instead of cutting losses or making your profits run, you do the opposite.
5. Familiarity Bias
You prefer to buy investment items that you are familiar with over non-familiar investment products despite the latter possibly being value adding to your portfolio.
6. Fear of Missing Out (FOMO)
You felt left out during the Bitcoin bull run back in 2017. In fear of losing out, you throw money at everything that seems to have the potential to shoot up without doing much research.
7. Framing effect
You base your decisions on how facts are depicted statistically. For example, ‘three out of ten investors of ABC are winners’ sound more hopeful to you than ‘seven out of ten investors of ABC are losers’. The two statements are, however, identical.
8. Gambler’s Fallacy
The probabilities of investment products performing are greatly underestimated or overestimated. If you hear that the prices are about to drop, you sell too soon and vice versa, even though the prices have not yet dropped.
9. Group Think
You display herd mentality by following whatever everyone else is doing because if everyone is doing it, they must be right. It does not matter that you are unable to confirm if the majority is indeed doing it, or the reason behind why they are doing it. You skip your own research and simply follow the group.
10. Hindsight Bias
On hindsight, you think that an event that has already happened seemed very predictable. How did people not see the 2008 and COVID-19 recession coming when there were so many clear signs? Since these last events were clearly obvious, you are tempted to take on further risks in the future.
11. Home Bias
You tend to buy stocks from companies in your home country because they appear more trustworthy. After all, you read it in your local paper while growing up and see the brand often. No other research is required as the brand is in your home country.
12. Loss Aversion
You are afraid to lose. Realising the loss of 10% in a stock is too much to handle and you would rather continue holding on and hoping for the best. Even if the stock falls a further 5%, you are too scared to sell it as you would lose more.
13. Mental Accounting
You think that losing $1,000 of your lottery win money is less painful than losing $1,000 of your saved up retirement funds. Although the dollar value is the same, you assign more value depending on the money source.
14. Narrative Fallacy
You enjoy reading or listening to stories and are easily convinced to purchase less desirable investment products just because it was marketed and sold in a better light.
15. Overconfidence
You overestimate your investment abilities, especially when the markets are on the rise.
16. Recency Bias
You recall the last piece of information best. If you made a poor investment choice before a good one, you tend to be overconfident since you last made a good decision. In a bull market, you forget about your losses made in a bear market since it was some time ago.
17. Regret Avoidance
If a blue chip stock that you are invested in does not perform as you’ve hoped, you think it is bad luck. However, if you invest in a niche product that does not perform up to expectations, you tend to regret this more than the blue chip stock. After all, you think that many other people have made the same mistake and thus your decision to buy the blue chip stock does not seem to be very wrong.
18. Representativeness Bias
After a short period of positive returns on the financial markets, you think that the world is now forever changed for the better. You arrive at a result too quickly based on imprecise information.
19. Self-Attribution Bias
You attribute successes to yourself and failures to external forces, and are thus unable to learn from past mistakes.
20. Sunk Cost Bias
You hold on to irreversible costs such as money, effort, or time and are unable to walk away. You find it tough to cut losses.
Plan your future with us
While easy to spot now, these pitfalls are often difficult to identify and avoid by yourselves when they happen. Seeking the help of a professional in this regard can be useful.
Seng Bingyang, Director of LFA said, “LFA is invested in not just our clients’ investment portfolio, but more importantly, their personal growth. Our discussions revolve around what they want to achieve in upcoming life milestones. We identify what is sufficient and lacking, finetune life goals, and work towards plugging any potential gaps together.”
“Here at LFA, we are more than just your trusted financial advisor. We are your life coach, a mentor, and a friend.”