Behavioral finance is such a big part of investing and is the reason why so many of us fail in the markets.
By knowing these common emotional investing mistakes. We can easily see what we can do to improve our investments.
Some may not be as easy to fix but knowing that we acted on emotions will help us in the long run.
Fear of Missing Out (FOMO)
Let's say there is this cool investment everyone's making money at. Now we want to join the investment since everyone else is making money at it.
Or we stay since well… everyone is making money at it. Even if it's something you wouldn't hold. Or the fundamentals are bad.
Sometimes it can be best to stay out of the investment, which might hurt when other people are making money.
Our regrets followed by FOMO are often due to the short-term movement of the stock price. Making us feel like we lost or made a bad investment.
Even if the long-term prospects of the investment are sound.
We can even look into stocks with poor fundamentals. And since the stock price has moved up it does look like an attractive investment for us.
And we want to join in since well… everyone is making money at it.
Don't chase any investments. If the bus has left the bus stop, wait for the next bus instead of chasing the one who left.
Follow a strategy and stick to it even if other people have made money in other ways.
We tend to rely on the first information we receive. Businesses abuse this.
The first information being completely irrelevant is very common. To make us more inclined to take the second information as good.
Struck prices next to new cheaper prices are because of this reason. We rely on the information that the old price was so high.
And now with the new price is far less we are more inclined to buy it.
The first price is an anchor and sets the standard for us. If the price was $10, the $5 now looks like a great bargain.
If I say that I value stock for
$100 and it's trading for $70, would you be more inclined to buy it?
We like to set benchmarks and while that's good. We have to try to set ourselves up for relevant benchmarks.
Since anchoring the first piece of information is most likely not based on any reason or system. Making this very dangerous.
When comparing something. Make sure the things we compare are useful information. By stripping away everything arbitrary.
The Sunk Cost Fallacy
If we have spent resources on something we have a harder time quitting on it. Even if we know it won't give us the desired result.
Making us lose even more resources by continuing.
Let's say we have started to watch a youtube video and were halfway in. Most of us will continue to watch it all even if it's bad. Since we already have spent the time.
Making us lose even more time by continuing to watch. We humans hate to be wasteful and to experience losses.
The sunk costs are gone forever.
And when we look at something to invest in we have to look at the resources we already have.
And not at the resources that we have already spent.
Loss Aversion and Prospect Theory
Losing $5 hurts more than a gain of $5. We focus rather on not losing than gaining.
A loss hurts about twice as much as a gain feels good. This is why failing feels so bad.
Why do people cover up their prior investment decisions? We have a harder time admitting a loss. And try to cover it up.
Many CEOS and people, in general, try to cover up their mistakes. And not to gain but to not lose.
When losing we tend to make all kinds of drastic decisions that we wouldn't make otherwise.
And the best thing may be to admit we did an error instead of escalating the whole situation.
Dunning Kruger Effect
People overestimate themselves when they cannot do that task.
When we learn about something we tend to think we know so much. But the deeper we go into something the more we understand what we don't know.
Making us question ourselves even more. And thinking we're stupid since we know so little about the subject.
So the less you know the more you think you know. And hence the more confident you are.
The more you know about something the more you understand how complex it is. Or you shut up since you think you know so little about it.
In investing this is very common indeed, we get investing advice from people who just started. Since they think they know so much.
And we tend to ignore the veterans since they understand how complex it is.
We like to look for information that supports our biases. We tend to think we're right when we're wrong. And ignore the facts against it.
And only lining up all facts that support our biases.
"A reliable way to make people believe in falsehoods is frequent repetition. Because familiarity is not easily distinguished from truth” -Daniel Kahneman
When researching investment we tend to look at the good side and ignore all other claims.
When we should be lining up all the good with the bad and making decisions on those facts alone.
We're all often wrong or don't know. But like to think we're smart.
Being humble is a good trait for making better investments.
Regret Aversion Bias
Regret causes emotional pain. This is why we sometimes tend to want to avoid regrets altogether.
We cant experience a loss if we never bought, right? Or we have to buy it now since it's a limited-time offer and we will regret it otherwise.
We have to sell it, so we won't have the regret of holding it.
Caution can be good but avoiding regrets altogether is bad since we need to take some risks to get some gains. But we also know that a loss hurts a lot more than gains.
Trying to perfect everything can sometimes lead to us not doing anything.
We cant always be rational since we have limited time and energy. This is why it can be good to sometimes do stuff not purely on rationality.
But we should still try to do everything as rational as possible. But doing 5 days of researching to see what $1 product you buy can be a waste of time.
We, humans, tend to satisfice rather than maximize. Instead of doing a cost-benefit analysis before choosing an opinion.
We assign different values to money based on what it should be used for.
If we would happen to stumble upon a $10 bill on the street, we are more inclined to spend it since its “not our money”
This is why gamblers play and lose more with “house money”
We assign different values to our money even when it has the same value.
I mean it's good we don't spend the money that should be going to food towards something else. But limiting money due to mental reasons can have some side effects.
Money should have the same value. A dollar found on the street shouldn't have less value because you found it.
It's only in our minds we make it different.
Having a mental accounting for food when food prices drop. Doesn't mean we have to or should buy more junk or expensive food.
But that is what happens to us when we assign those accounts.
Peer pressure isn't only for teens but for investors too. Confirmation of our investments is something we want to have.
The less we know about an investment the more likely we are to care about what others think about it.
And if a lot of people talk good about an investment, it has to be good right?
A lot of the time stocks that everyone talks about has had an awesome gain. And we also get swayed by the fear of missing out.
Herd mentality can be good but always do your research. And thinking for yourself first is key in doing good investments.
Since many times these investments everyone talks about were great once. And have become overvalued since then.
And it can hurt to miss out on those investments. But when the investment finally drops in price and you are out of it is a great feeling.
But It hurts when I should have gone into an investment that would have led me to 14 times gains.
But going in when it has already gone up 14 times with bad fundamentals may be bad.
Doing our research and trying to ignore what people say before investing can help us.
Since we most likely use irrelevant information as a benchmark. So by ignoring what people say and how much it has already gone up we can do better investments.
When we have spent any resources on investment. We are more likely to continue to spend resources on it even if it's bad.
So it can be a good practice to try and stop even if we have lost resources.
Ignoring short-term fluctuations is most likely a good idea if we have done the research. Since many of our emotions do come from short-term price fluctuations.
We may think and investment is bad only because its price has dropped in the first week since we bought it.
Remember it can take years for an investment to pay off.
Books on the topic:
beyond greed and fear understanding behavioral finance and the psychology of investing
The Little Book of Behavioral Investing: How not to be your own worst enemy
The Behavioral Investor