We’re all familiar with the stories of legendary investors. They’re the men and women who make their fortunes by decisions that are often complex, sometimes contrarian, but always able to be explained in hindsight. They make and preserve their wealth in good times and in bad. And it’s not simply because they had a lot of capital to start with.
Many of us yearn to have the cold, hard robotic logic of the world’s most successful investors. Unfortunately, we ordinary folk are governed by something a bit more basic. Something that even those stock market legends had to struggle through at the very start.
How does psychology influence the way we invest our money?
Investor psychology is a subset of behavioural psychology. It overlaps with fields such as behavioural finance and behavioural economics. As the name suggests, it focuses on the observable behaviour of investors. Many academics relate investment decision making to other decisions with the same characteristics. Important decisions that are driven by deep-seated emotions such as fear and greed.
In other words, irrational decisions.
These choices aren’t made by analysing the numbers, but by looking at what everyone else is doing, and being driven by the prospect of loss (or reward). Several quantitative analyses suggest that about 90% of investors sell within 10% of the bottom of a market cycle. The same proportion buys within 10% of a peak. This is a pattern of group behaviour known as escalation of commitment. You’ve probably heard of the ‘sunk cost fallacy’ – that’s a big part of it.
This type of group behaviour can push up the market value of stocks to extreme levels very quickly – a.k.a. a bubble. People want to get in on (what they perceive as) a good thing “before it’s too late”. And it can cause a crash when people see the first price dips and try to get out before they lose it all. Think of the Chinese stock market bubble and crash that happened mid to late last year. Some Aussie commentators continue to argue that a similar situation is unfolding with our capital city property markets, but that’s a discussion for another day.
The good news is, there are ways to avoid being swept along with the herd. It’s all about self-awareness. That includes knowing when you’re out of your depth and need to seek advice.
Consider the following.
Tips for overcoming the urge to buy (or sell) everything
- Before you buy in to a ‘hot’ opportunity, ask yourself whether confirmation bias could be making it more attractive. Just because similar investments have done very well, doesn’t mean this one will. See, for example, the wildly popular IPOs for certain tech stocks.
- Before you sell just to ‘get out quick’, consider the alternatives. Is this stock likely to recover? If so, how long will it take? What is the opportunity cost of sticking in there for the long(er) term?
- Consider contrarian opinions. Alternatively, be your own devil’s advocate. Don’t make a major decision without giving yourself time to gather and consider a well-rounded set of data interpretations.
- Before deciding what to do with an individual stock, take a holistic view of your portfolio. How will buying (or selling) this one stock affect the rest of your portfolio? Is it, in context, a good fit for your needs?
- Look at long term data to get a better idea of whether a share price dip is the beginning of the end, or just a temporary correction.
- Overcome your fear of doing something different investment-wise by tapping in to our expertise. If you don’t know the first thing about technical analysis, we’re happy to help.
Avoiding the pack mentality
Are you confused about how to deal with an asset in your portfolio? Feel free to contact us for balanced advice and a holistic approach.