Classical Economics states that we are rational decision-makers. But we have proved it wrong, haven’t we?
This is particularly true in investments where many people have shown nothing short of absurdity.
This absurdity has brought in a popular concept called Behavioral Investment.
In layman’s terms, behavioral investment is a combination of psychology and investment. It covers a lot of important psychological traps that many investors fall into often.
- Disposition Bias (I have fallen for this many times!)
- Fear of Regret
- Illusion of Control
- Confirmation Bias
Most Common Psychological Traps
1. Disposition Bias (I have fallen for this many times!)
Don’t you want to earn your profits as soon as possible? Don’t you want your losses to turn into profits in the future?
This is exactly what causes Disposition Bias. When the price of our stock increases more than the price we paid for, we want to gain the returns as soon as possible. It is to avoid the possibility of its price falling down later on.
Similarly, when the price of our stock drops below our buy price, we tend to hold them to avoid losing. Rather than admitting our mistake in stock-picking, we hope for the market to return to its initial price.
Talking about myself, I have held my losing stocks a lot. I don’t like to see negative returns in my stocks, so I wait for them to break even. But, in doing so, my declining stocks have performed worse, and I lost even more than I would have had I sold them earlier.
It’s a big Challenge for me because I’m a Millennial. I am trying to tackle it before it gets too late.
2. Fear of Regret
As the name implies, Fear of Regret means that we would do an activity to avoid regret not doing that in the future.
Let’s suppose you have bought some Amazon stocks at $2,000. Then, you see the price increase for the past few days, which has currently reached $2,100.
You might have initially wanted to hold the stock for a long period of time. But you start thinking “Should I sell them now to earn a profit of $100? What if the stock falls to $1,800 later?”
With all these questions running in your head, you sell them at $2,100 without researching much.
In other words, your behavior was solely based on your emotional situation.
“Invest today or regret tomorrow.”
3. Illusion of Control
The illusion of control occurs when a person believes he has control over an outcome. Practically, this might not be possible all the time.
As human beings, we like to think that we are controlling our life and what happens with it.
For example, you recently bought some Microsoft stocks at $150. Then, you start to believe that you are able to influence its price movement (when in fact the buyers and sellers decide the prices).
Providing another example, a lot of gamblers believe that they can win if they roll the dice harder. Rolling the dice in anyways won’t decide the result of the number that will show up. But since people like to be in control of their outcome, their subconscious urges us to control random events too.
By believing that we are able to control the outcome, we risk too much in the stock market. We simply trade too much and under-diversify our portfolio.
Trading too much leads to high brokerage costs while under diversification results in the risk of losing all our money at once.
This concept is well explained in the Best Investment Book Ever written, The Intelligent Investor.
“Uncertainty is an uncomfortable position. But certainty is an absurd one.”
4. Confirmation Bias
People try to look for information that supports their belief and ignore those going against it.
Let’s say you plan to buy Coca Cola stocks. then you hear the news that a lawsuit has been filed against Coca Cola that could cost billions of dollars.
As you were looking forward to buying its stocks, you will ignore the consequences of the lawsuit. You will view it as irrelevant information.
Why would you do so? Because it contradicts your belief. In your mind, you have already confirmed that Coca Cola is a great stock.
“Ever since I learned about confirmation bias, I’ve been seeing it everywhere.”
Anchoring involves using past information for evaluating the value of a stock which might be irrelevant now.
For instance, you had bought the stocks of ABC Co. at $100 five years ago. Disregarding its financial performance over the years, you still believe that the value of ABC must be $100.
Today, as competition has decreased its profits over time, the price of ABC is at $40. But, since you bought the stock for $100 earlier, you still believe that the price will increase to $100 soon.
Anchoring is similar to confirmation bias in some ways. Both of them make us miss out on important details about our investments. These details might seem trivial, but the risk of losing is enormous.
“If you find yourself getting excited over any investment based purely on its price, you’re anchoring.”
So which psychological trap do you think is the most dangerous one? Have you even fallen for one of these?
Thank you for reading it till here. The 2nd Part of this Series can be found in the next link. Please feel free to read it if you want to learn about the techniques to Overcome these Biases – Ways to Overcome The Investment Psychological Traps– Part II.