Investing psychology is an innovative sub-area of research in behavioural finance that explains exactly how the investor’s judge, predict, investigate and review the process for decision making that includes information gathering, defining and understanding research and analysis.
Psychological factors can greatly influence our decisions and gradually the outcomes on a personal and collective scale in the financial markets.
Let’s dive into some investing psychology traps beginners should avoid in the stock market.
Common investing psychology traps of Fear, Greed, Hope and Regret
Regret is an emotion associated with the individual wishing that they shouldn’t have performed a past action. It’s been found that traders are less likely to purchase a stock that they have previously sold at a loss. Especially if the stock price is trading at a higher price than their selling price.
Buying at a higher price than what one is previously sold a share can remind the trader that they have made a mistake in selling the share or vice-versa.
Hope is associated with the belief that the future would turn out to be positive. It’s found that when a stock price decreases traders will sometimes continue to hold onto the stock because they hope that there will be a turnaround in price.
They become insensitive to evidence that the stock price will continue to decrease. The investors do not sell in hope to recoup the losses even when they could redeploy the investment to a more promising opportunity.
Trading based on hope is also a type of optimism bias
Greed is an emotion associated with an insatiable longing for wealth, power and status. Greed is a destructive emotion because a greedy person will not reach a point of satisfaction and will always yearn for more.
Greed is also a social emotion with which you can get easily infected by the people around you who have this mindset. This can drive the fear of missing out and cause you to divert from disciplined investment strategies.
When many investors become greedy it leads to a pricing bubble which represents a spike in the share price that does not reflect the long term in terms of investment option. Investors buying stock during a pricing bubble often end up losing money as the long-term fundamentals ensure that share price returns to a lower level in a bull market.
Fear is an emotion associated with the detection of a threat or possible harm. In the case of the stock market, there can be a fear of losing one’s investment. Many traders invest their hard-earned cash in the stock market with the hope of making money and when the prices decrease the investor sees a paper loss.
The emotion of fear leads to panic buying and selling by the investor to recoup some of their investment. Fear like greed is also a socially contagious emotion.
When many investors experience fear the stock price of a stock can plunge lower than the fundamental long-term price.
Fear, Greed, Hope and Regret are very common investing psychology traps as they are associated with basic human emotions. Every investor at some point of his investing journey does go through at least one of these emotions. The best way to overcome these traps is to follow fundamental investing principles and to make a habit of investing regularly.
Seeking investors reward with the behaviour of a speculator
Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.Warren Buffett
A speculator is one who wants to profit from the fluctuation in the market. They are people or institutions who do not have any fundamental knowledge about a company.
Speculators or forecasters invest at a time when volatility is high. The investment is high and for a very short period. Speculators can win big but can also lose everything.
If speculation is so useless then why do people keep blindly following it?
The reason is, when given a number we tend to cling to it even subconsciously, a trait known as anchoring. Just giving someone a measure such as value at risk means that they will start to hang onto it, even if they are aware that such measures are deeply flawed.
All investors should devote themselves to understanding the nature of the business and its intrinsic worth, rather than wasting their time trying to guess the unknowable future. The idea of investing without pretending you know the future gives you a very different perspective and once you reject forecasting, you will free up your time to concentrate on things that really matter.
Investing psychology trap of working in the extremes
The intelligent investor is a realist who sells to optimists and buys from pessimists.Benjamin Graham
Many investors as they start getting some success they fall into the trap of working in extreme brackets.
This means that an investor would only trade a stock either when it’s price falls too low or skyrockets to a new high. Working within extreme brackets is too dangerous as nobody can predict what the actual bottom or the highest price that a stock will hit. This leads to the investor either buying stocks at a higher price or selling it at lower prices than predicted.
The psychological trap of living in the past
If past history was all that is needed to play the game of money, the richest people would be librarians.Warren Buffett
Investors especially beginners cling onto the past performances of a particular stock. Past performance of a stock is not a benchmark to look at for predicting its future.
While investing in stock always study the of the company rather than hanging onto its past performances. Study whether profits produced in the past were justified by its fundamentals or not. The most important thing to remember is short term trends of the past might not get repeated in the future.
Falling prey to emotional traps
If you cannot control your emotions, you cannot control your money.Warren Buffett
One of the biggest hurdles to the growth of new investors is their own emotions. Most investors make their trading decisions on an emotional basis, rather than on a logical basis.
Emotional investors sell off their investment when the stock price is dropping and buy when the price is going up. The fundamental investment mantra is to ‘Buy low and sell high’, a lot of investors end up doing exactly the opposite thing.
Buying small, penny and unknown stocks
Big companies have small moves, small companies have big moves.Peter Lynch
The most common type of stocks that many inexperienced investors are drawn to are the penny stocks.
Penny stocks are shares of a company that trade for very low amounts. Penny stocks are offered by companies having very small market capitalization, little to no profits and minimal operations. They are often not listed on major exchanges because of their low credibility.
People buy these stocks because they fluctuate tremendously in price, which appears to create an opportunity to gain high-returns quickly. It often turns to be the opposite, penny stocks can wipe out your savings in the blink of an eye.
Poor Time & Money management
Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.Warren Buffett
Time management is prioritizing tasks and establishing a distinction between what is important and what is urgent. Timing is very important when it comes to investment. Inexperienced investors generally tend to be impatient before buying a stock. It’s necessary to decode the valuation of stock at the present moment rather than buying or selling it at its current price.
Patience is the key when it comes to investment. Knowing where to invest is important but knowing when to invest is the key to gaining higher profits.
Money management is a strategic technique to make money yield the highest interest output value for any amount spent.
Poor financial money management can lead to severe budget consequences. If you as an investor are not being able to manage your money whether you earn low or big, you will probably find yourself in debt soon. As an investor, you must be aware of your appetite to take risks. Analyze how much risk you can take and divide your investment accordingly.
Taking uncalculated risks
Risk comes from not knowing what you are doing.Warren Buffett
The risk-reward ratio measures how much your potential reward is, for every dollar you risk. Many investors use the risk-reward ratio as a tool to compare the expected returns of an investment with the amount of risk they must undertake to earn these returns.
Amateur traders often justify bad investments where they are not trading within their system with a larger risk-reward ratio. You have to stick to your trading plans for a reason and a bad trade does not get shadowed by randomly hoping to gain a larger risk-reward ratio.
People buy/sell but hardly accumulate or distribute
If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.Warren Buffett
Amateur investors love to buy and hold stocks for a short period but they hardly seem to accumulate them. Similarly, sell these stocks when the price starts to get high but they forget to distribute their stocks into lots and sell accordingly.
Use Pyramid Investment strategy
A pyramid investment strategy is an investment strategy that allocates assets according to the relative risks involved in various levels of investments. The base of the pyramid consists of low risk-investments, the middle-portion is composed of volatile or high-risk investments. The key benefit of investing in pyramid strategy is that it allows the investor to increase their position and their potential profit, without increasing their risk.
Asking too many people for advice
Honesty is a very expensive gift. Don’t expect it from cheap people.Warren Buffett
As an amateur investor tends to ask for advice from experts or friends who can tailor to his or her advice in a specific situation. It is very necessary guidance as a newbie investor in the stock market to avoid investing in worthless stocks.
Today in the digital age, seeking expert advice has become easier than ever. If you put on a business channel you can easily find financial experts analyzing the market & offering recommendations on stocks that investors can consider. Following these experts blindly or following the market trend without analyzing whether the recommended stock fits into your investment plan can be risky.
Asking too many people for advice on investing can be difficult for you to distinguish between good signals & noise. Avoid following advice without thinking, otherwise, you will often find yourself selling stocks that you should hold, and buying stocks that you didn’t want.
Investing in a business that you don’t understand
Never invest in a business you cannot understand.Warren Buffett
One of the easiest way to fall into the trap of investment psychology is by getting involved in overly complex investments. Most of us have spent our careers in a particular field or either collaborated with people in different fields. We probably have a randomly strong group of how these businesses work make money.
A majority of beginners are lured by businesses or industries that they do not understand. This doesn’t mean that one should not invest in new ventures but analyzing their business and investing with caution is important.
It’s difficult to determine what factors would affect the stock price and by how much? Instead, invest in a business whose fundamentals are strong. Remember time is always a friend of investors in good business.
Psychology of having a selective memory
Those who do not remember the past are condemned to repeat it.Benjamin Graham
Another investing psychology trap overconfident investors fall prey to is selective memory. It is a common psychological trap that all of us sometimes fall prey to regardless of what we do. Many of us only remember events from the past that were unpleasant, particularly one for which we were solely responsible.
Being selective about memories whether they were good or bad decisions, can be very misleading in terms of your present investment plans. Thinking about short-term loss or gain in the past can weigh down your long-term strategy.
Instead of selectively remembering events from the past try to analyze the factors that lead to those decisions. Analyzing things can prevent you from overthinking about such past events and give you a clear strategy for your future investments.
Over-reacting to market swings
You will be much more in control, if you realize how much you are not in control.Benjamin Graham
Amateur investors tend to be optimistic when the market goes up, assuming it will continue to do so. Conversely, they become pessimistic when the market sees a sharp fall.
Over and under-reaction is a result of investors overconfidence in the past results and his knowledge of investing. Market has no strings nor gravity. Basic nature of the market is to rise and fall.
Time is always a friend of investors in good business. Time creates as well as erodes wealth. All depends on the quality and the performance of the company. Biggest parameter, in the long run, is always Earnings, earnings and earnings.
Stock prices swings in the extremes with optimism and pessimism. Winner is one who buys from pessimists and sells to optimists.
Following a bad investment habit
Chains of habit are too light to be felt until they are too heavy to be broken.Warren Buffett
A thought becomes an action, and action repeated over time becomes a habit. Successful investors are people with just good investment habits.
Many new investors though start very well in the beginning, later their investment stops to yield gains that they got before. With time and situations, they keep on changing their investment plans based on the noise that’s echoing around. Sure, you have to be open and flexible in your investment plan but constantly changing your plans without any solid evidence hampers your growth in the market.
Smart investors have specific financial goals and invest intentionally with specific goals, coming up with an investing strategy becomes easy, and effective.
Successful investors know how to invest regularly. The best way is through a systematic investment plan(SIP), where you can invest a fixed amount regularly regardless of the market conditions.
Replacing bad habits with good one’s is not easy but you can achieve it by sticking to your financial goals. The market knows too many things in advance. Masses know their risk-taking capacity but the problem comes with risk-taking ability.
Investing psychology trap of ‘Superiority’
Success is a lousy teacher. It seduces smart people into thinking they can’t lose.Bill Gates
A common psychological trap that many investors fall prey to as they get a bit experienced in the market is the ‘Superiority trap’. Believing that they have seen and learnt it all is a major misunderstanding that even some experienced investors have.
Many investors tend to think that they know better than the experts and the market. Even if you are experienced enough you are still vulnerable to the dangers in the market.
Many expert investors have been misled by this psychological trap and have lost fortunes in the market. Market knows too many things in advance. Investors know their risk-taking capacity but the problem comes with their risk-taking ability.
Some investors tend to make the same mistakes again and again. They do not seem to learn from their mistakes or avoid realizing losses, desperately seeking the comfort of other investors, shutting out reality completely.
Knowledge alone is never a power, Knowledge with implementation, experimentation and modification with an urge of learning is- Power.
Investing Psychology traps- Conclusion
Human psychology is a very complicated thing. It is very easy to fall into some of these traps in the heat of the moment. Fear, Greed and Hope are very basic of human emotions that can easily lead an investor astray. This is where investing psychology comes into play.
Investing psychology determines how an investor’s portfolio will perform in the stock market because investment decisions are directly linked to emotions. Overcoming these investing psychology traps seem to be very difficult but with the right knowledge, habit and implementation one can overcome these traps within less time and difficulty.
As an investor, you must always be aware of these traps and be honest about your shortcomings. Do not hesitate to seek advice from competent, knowledgeable and well-established people so that you never lose the grip of reality.
These were the investing psychology traps beginners should avoid in the stock market while starting their investing journey. Do let us in the comment section which trap did you fall into and how you overcame the situation?