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Investing can be frustrating, can’t it? You can read a hundred articles and a dozen books on investing; for some reason, your investment returns still refuse to improve. To make matters worse, sometimes an ordinary Joe with no background in finance will come along and outperform you! In fact, they may, for a while, even outperform experts in the field. Why might that be?
Well, unlike other fields of expertise, you can argue that education, experience, resources and connections, while still vitally important, come secondary. The most important factor in investing is psychology and behaviour, which is why the topic of behavioural finance even exists! You can have all the knowledge in the world, but if you’re not aware of and in control of your investing psychology, you will be prone to biases, emotional decisions or irrational assumptions.
Fear, greed and ego (or pride) are three of the most controlling emotions that investors usually face. Let’s take a look at them!
The fear of potential losses is something all investors have in common. After all, who would want to lose their hard-earned money? We’re not saying that any amount of fear is bad, though; it’s good to have a sense of risk-aversion, but too much risk-aversion is a problem because it will limit your potential upside. As we all know by now, investment products that have high potential upside will always come with high risk as well. It’s best to find a healthy level of risk-aversion that suits your financial goals and your current financial situation!
Another scenario where fear may control you is one that every investor will be familiar with, and that is when our open positions are loss-making. Whether it’s stress, frustration, or panic that initially overwhelms you, remember to take a step back and clear your head before doing anything. Do your research to understand why the market is not responding or moving as expected, and then make your decision.
One simple way to think about it (unless you're in a country with capital gains taxes where you can "harvest a tax-loss") is that holding onto your shares at the current price is the same decision as choosing to buy them at the current price, regardless of where you originally bought them. This also applies regardless of the price yesterday or whenever you last thought about selling/buying more of those shares. Simple idea, but very difficult in practice!
Greed is rather straightforward. It’s about chasing after higher and higher returns. Sometimes, investors hold their positions open for too long, and when the market reverses, they lose everything they had made. Prudence is the key when deciding when to close a position (whether at a gain or a loss).
Selling too early when the stock or market is rallying hard and in a bull market is also a nightmare! Do you buy back at a higher price after you "sold too early"? What if you sold at a loss and then the stock rallied?
Greed is also about biting off more than you can chew; don’t take on a level of risk that you aren’t prepared to deal with when things go wrong. Prepare yourself by having enough knowledge of the shortlisted shares/financial instruments, having sufficient capital and being in a proper emotional state before making risky purchases (including buying on leverage or using derivatives).
Investing isn’t a competition against your peers; it’s about achieving better returns than other readily available alternatives (e.g. bank accounts or a unit trust from a fund manager you've vaguely heard of). Don’t worry too much about what others are doing. You may want to go to them for advice, which you absolutely do not have to act on (even at the risk of the dreaded "I told you so" from them!), but you should always quell that competitive side of you that envy or frustration can control.
An inflated ego because of past or recent successes may easily lead to overconfidence. It’s important to always base your investment decisions on facts and all available information and not just your gut feeling or instinct. This gut instinct is never 100% reliable, and for many people, even professional investors, this may never move much out of the 50-50 range, i.e. totally useless!
As we get more experienced with investing, we start forming our own opinions and biases about the financial markets. Based on preconceived notions that may not be entirely true, bias can greatly hinder your decision-making. Remember, we’re dealing with financial markets here; they are sometimes volatile and always unpredictable. Having strong biases may deter you from doing proper analysis and research due to overconfidence.
So, it is extremely important to be aware of your biases. Here are some common ones that many, many investors have:
Representative bias refers to the thinking that every similar trade will lead to the same outcome. This bias may compel you to try and replicate trades that have been successful in the past without carrying out proper analysis/research on the current market conditions or financial instruments. Granted, markets may follow certain price or volume patterns, sometimes due to market behaviour, but this is bound to change without prior notice. As we’ve said, the market is unpredictable. Hence, you should approach each new trade with due diligence, treating it separately from past trades while at the same time learning from experience.
Negativity bias may compel you to only focus on the flaws of the strategy and not recognise the positives. Due to this bias, you may never truly learn what works. The reasoning is that you’re blinded from the positives of any flawed strategy until you find a strategy that is 100% foolproof (which doesn’t exist). As such, investors need to holistically analyse their strategy to find out what went wrong and what went right. By understanding what went wrong and right, investors can tweak their strategy to make it work instead of starting from scratch every single time.
The endowment effect refers to the irrational overvaluing of objects that one owns. This bias often occurs with things that have an emotional or symbolic significance to the owner. This includes purchasing financial instruments bought as an investment, causing the owner to perceive its value at above the market price. Just the mere possession of the object may be enough to trigger the endowment effect.
The two main triggers of the endowment effect are:
This bias refers to seeking out and giving greater importance to news and information that fits your current viewpoint. The information available on the Internet may be contradictory, and it may be difficult to determine what’s right or wrong. However, we don’t believe that things are always black and white; there is always insight to be gained. We urge investors not to disregard news and information that may contradict their current beliefs and understandings of the market. Instead, read it critically and ponder why those opposing views exist to get a more holistic perspective.
On the flip side, if news and information contradict your current viewpoint, this could lead to cognitive dissonance. Cognitive dissonance comes from believing in two contradictory things simultaneously, resulting in confusion and possibly anxiety. Ultimately, this leads to irrational decision-making.
The Gambler’s fallacy is a tricky one. It refers to investors believing that a particular event is more likely to happen due to past events. For example, if I toss a coin ten times, one might think that it’s likely to finally land on heads after landing on tails the first 9 times. That is untrue. The probability will always be 50/50.
The word “gambler” is worth noting in the gambler’s fallacy. The distinction between investing, speculative trading and gambling may not be so clear-cut because luck plays a significant role in all three. Speculative trading and gambling also exhibit significant overlaps around addiction.
"The conceptual and empirical relationship between gambling, investing, and speculation" in the Journal of Behavioral Addictions (Arthur, Williams, Delfabbro, 2016)
More information on investor biases and how to avoid them here.
Luck is impossible to quantify, and it’s sometimes rude to suggest the amount of luck involved in people’s successes. The fact of the matter is that luck plays a huge role in investing. There are so many factors that affect the prices of our financial assets. At the end of the day, supply and demand determine market prices. We can do our due diligence, study market behaviour and be up to date on the news. Ultimately, it’s all to predict what the millions of other investors will do. We’re never 100% correct.
Don’t underestimate the role that luck plays in your success. Keeping the impact of luck in our minds will keep us humble and prevent us from getting overconfident. Of course, don’t overestimate its part in your failures as well. Doing our due diligence, analysis and research go a long way in predicting where the market will swing (even if it won’t always be right). As they say, "the harder you work, the luckier you get"!
Addiction to Online Trading
What exactly do traders with gambling-related addictions exhibit? They may feel compelled to perform trades throughout the day, be preoccupied with thinking about trading while doing other things, increasing the amount of money used in trading or taking on increasing levels of risk. At the end of the day, gambling disorders may lead to a significant monetary loss, especially because irrational decisions involve large sums of money.
In fact, most addicted traders tend to follow the same pattern: experience early wins, gain confidence → experience losses and hence increase investment amount in hopes of recouping losses → losing control and losing a large sum of money.
If you’re unsure if your trading habits exhibit any of the above biases, do get a second opinion on it. It is hard to get a clear view of your habits when you’re so close to them.
By now, you may have heard of financial bubbles. The biggest recent examples of financial bubbles are the dotcom bubble in the late-1990s and the global financial crisis (“The Lehman Crisis”) in 2007-09, ignited by the US housing bubble. Both ended in massive crashes.
The term “bubbles” comes about from the initial price surge of a type of asset or group of assets seen as inflating a giant, fragile bubble. Once the bubble pops, i.e. when investors realise that the assets are drastically overpriced and overvalued, the price comes tumbling down, creating waves of losses for investors who are still in. Obviously, no one wants the wave to catch them. Economists have identified 5 stages of a financial bubble that all investors should know about.
Investors start looking more keenly into the topic when they get excited about something new or unconventional. If this new topic has potential, investors start pouring their money into it. Examples of this include new technology leading to the dotcom bubble or historically low mortgage rates leading to the housing crisis.
This excitement then leads to an increase in demand for a certain financial instrument that is related to the source of excitement. The sudden increase in demand leads to a large rise in prices, attracting news coverage and discussion, giving the financial instrument even more publicity. This leads to a growing cycle of overexcitement as the number of investors and capital involved increases exponentially.
The price is rising, and caution is thrown to the wind. Even with extremely high prices, investors are willing to pay even more because investors expect it to continue rising. Hence, prices continue to climb and climb and climb. Yes, this is the classic situation in which your taxi driver is trading stock tips with you, and friends are quitting their jobs to become full-time "investors" in whatever asset happens to be booming at the time.
Once the price is too high, earlier or more risk-averse investors start to pull out, taking their profits and leaving the market. (Some may even initiate short positions)! As more investors seek to sell, the price hikes begin to slow, alerting other investors that a reversal may be coming because, deep down, many investors will have been asking: “Has the price already run too far, too fast? Can we justify valuations expanding even further? How high can this possibly go?”
It’s pretty much impossible to pinpoint the exact point where distress will hit the market. After all, by this point, most investors aren’t trading rationally anymore (at least based on classical investing fundamentals).
It doesn’t take much to burst a bubble. However, once enough investors realise that the disparity between price and "value" is too much, or if they expect the price to start tumbling for any other reason, it will. When people start pulling out, others will panic and start pulling out as well. Prices reverse and fall just as fast, if not faster than they rose. Investors scramble to sell the asset to prevent further losses, leading to an even faster price fall as supply overwhelms demand. This process is especially the case when potential buyers are happy to withdraw their bids, sit back and look to come in at lower (and lower) prices.
Bubbles are obvious in hindsight, and it’s relatively easy to pinpoint the 5 stages after they have occurred. However, while it is happening, it’s hard to tell, and that’s why they still occur. So, it is imperative to be on the lookout for such bubbles. By paying attention to how you trade and your investing psychology, you can prevent yourself from entering positions simply for the “hype” and getting sucked into a financial bubble that you didn’t even know existed.
INVESTING PSYCHOLOGY. COMPLETED. ✅
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