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Psychology and investing

2020-11-13, Michael Thompson

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Psychology and investing

When it comes to investing, experts believe that psychology is more important than IQ. Warren Buffett once said "Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ.” Isaac Newton, one of the smartest humans in history, lost a fortune in South Sea stock. In this article, we explain psychological mistakes that could hurt your investments. Avoid these and you could boost your returns significantly.

The Overconfident Investor

Many investors suffer from what psychologists call illusory superiority - overestimating their abilities relative to others. This psychology often results in the behaviors listed in subsections down below. In short, before you make an investment ask yourself if you really have an insight that trumps the thousands of man-hours of research and analysis that went into the current consensus (the market price of the asset).

Active Investing

Overconfident investors tend to trade excessively. Studies like this show that active investors earn significantly lower returns than their more passive counterparts. Studies indicate that it's better to think carefully about a long-term plan, write it down (including the reasons behind it), and revisit it before making changes. You can read more about this here.

Poor Diversification

Overconfident psychology leads to poor diversification. The overconfident man concentrates a large percentage of his investment in one or a small number of assets, believing he can cherry pick the best assets. As mentioned above, even Isaac Newton did this. When right - or just lucky - this psychology provides marvelous returns. However, the price of an asset is a consensus normally reached after thousands of hours of research and analysis by hundreds of professionals and experts in the field. On average, you're not going to outperform them. Over the long run, you’ll pick average performing stocks while exposing yourself to a larger downside risk. For more information about this risk see this article. Ironically, the people who initially succeed in this endeavor typically lose the most. Such people make a lot of money early on, feed their overconfident psychology, and eventually lose with a larger, more concentrated portfolio.

Self-Attribution

There’s a psychological tendency for us to take credit for our good investments, but blame our poor investments on external factors. “I earn 50% annual returns” a man says. In reality he may have one or two stocks that earned that, with a total return (on all his net worth) below 5%. He blames the poorer investments on external factors: “I didn’t count that because my friend told me to buy it; it wasn’t my idea.” “I just held all that excess cash to be safe.” We need to take responsibility for all our savings and investing, not just a subset that looks good. Otherwise, this psychology feeds overconfidence that leads to the former problems, harming investments in the long-term. You can read more about self-attribution psychology in investing here.

Selective Memory

Our psychology often causes us to remember our good investments, while forgetting our mistakes. Many successful people will tell you that mistakes aren’t such a bad thing - they may be the best learning aids. Not capitalizing on these learning opportunities is a big mistake itself. Note your mistakes and try to avoid repeating them. Forgetting mistakes is another avenue that can lead to overconfidence. You can read more about selective memory and investing here.

Failure to Accept Loss

After investing in an asset you think will beat the market, you may continue to hold it even after your very reason for purchasing it is invalidated. Once you’ve lost money, you may refuse to sell an asset at a loss. In psychology, this is called a sunk cost bias and you can read more about it here.

Confirmation Bias

We have a psychological tendency to ignore or discount information inconsistent with our existing thoughts. We’re predisposed to conversing with people who agree with our views, and reading articles that back up our beliefs. This is called confirmation bias. Ray Dalio, founder of the world’s largest hedge fund, says that it’s more helpful to talk with those who disagree with you and try to see things from their perspective. Likewise, we recommend you read articles counter to your investment beliefs. You don't have to agree with them, but give it an honest chance and then try to re-evaluate things objectively afterward. Sometimes you’ll find error in your ways.

Recency Bias

Recency bias is prevalent in investing today. Recency bias involves overweighting the recent past when making decisions. For example, an investor may buy more of a hot tech stock today because his purchase last week was so successful. He may deviate from his long term investing plan based on what he’s seen in the last month. This psychology also explains why investors tend to get confident during bull markets and overly fearful during bear markets. Read more about recency bias and investing here.

Investing in your Comfort Zone (Familiarity Bias)

Psychology says a software engineer will typically invest more in tech stocks than a healthcare professional, and vice versa. Experts say this is OK in moderation, but extreme cases of this destroy the benefits of diversification. If the tech sector has a bad stint, the software engineer may lose her job and investments simultaneously. We've even noticed employees investing substantial amounts in their employer's stock, an even more dangerous lack of diversification.

Loss Aversion Psychology and Investing

Some people have jumped into markets at bad times, lost money, and then decided "I'll never do that again." Psychologists tell us that the pain of losing a certain fraction of our investment trumps the joy of gaining the same amount. This can lead to a condition that psychologists call loss aversion - being overly cautious to avoid losses. We should look at the longer-term history, not just our own experience. Very conservative investing doesn’t compete in the long term. Some people have an irrational belief that they control the markets: "as soon as I buy in the market will collapse, that always happens to me." Do you really think everyone is watching you to decide when to buy and sell? If you suffer from this, you could review historical returns of different indices (say the S&P 500) and try dollar cost averaging.

Investing and the Psychology of Irrational Exuberance

The term irrational exuberance was popularized by Alan Greenspan. It refers to situations where asset prices soar above reasonable fundamental valuations due to psychological factors like fear of missing out (FOMO). Despite the fundamentals, investors buy an asset assuming the price will continue increasing.

A recent example of this was Bitcoin in 2017. Many people, after earning extraordinary returns, continued to buy more and tell their friends. Many of those friends bought and told their friends. The value of a Bitcoin increased 1000% in short order. Some people initially skeptical of Bitcoin went ahead and bought in just to avoid being left behind (some even did this on credit!). In their fear of missing out (or exuberance from recent gains), many ignored simple facts that would have indicated the risk they were taking. For example, Warren Buffett publicly gave many warnings and the simplest look would have revealed that Bitcoin had a history of explosive growth followed by 80%+ losses.

No matter how great an investment may seem, always try to realize that bad times will come. If people are in a frenzy over it, the bad times typically come soon. Warren Buffett once said "be fearful when others are greedy." Try to objectively weigh the thoughts of the naysayers and avoid confirmation bias. See this article for more information about the psychology of irrational exuberance and investing.

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