Many investors believe that investing chiefly involves analysis, calculations, and stock selection.
While the quantitative aspect of investing is undoubtedly important, what you may fail to appreciate is that emotions play a major role in investment success.
With your hard-earned money on the line, it is not surprising to feel emotional about your investments.
However, these emotions could end up sabotaging you and negatively impact your investment results.
Here are five important psychological traps you need to be wary of to ensure your investment process remains rational and objective.
1. Hindsight bias
If you ever felt that you knew something was going to happen before it did, you are suffering from a classic case of hindsight bias.
Hindsight bias describes a situation where knowing the outcome of an event causes you to believe that you had always known how the situation would pan out.
This phenomenon may sound harmless, but when investing, it breeds complacency as you are lulled into a false sense of security.
By assuming that you knew the outcome of an event before it happened, you end up feeling overconfident in your abilities.
This overconfidence is dangerous when deploying capital for investments as you may feel overly confident of a specific outcome without considering the risks and other possible outcomes.
There is an easy way to prevent hindsight bias – keep a journal of all your investment decisions and the thought process behind them.
By checking back on these decisions, you can assure yourself that your success rate at forecasting is probably much worse than what you initially assumed.
2. Confirmation bias
Confirmation bias is a type of defence mechanism your brain employs to protect you from opinions or facts that contradict your own.
Hence, if you hold onto a belief, your mind will search for confirming facts or evidence to support that belief and reject all other evidence.
Confirmation bias will get in the way of good research into a potential investment.
You tend to look for information that confirms your belief in an investment and methodically reject evidence that goes against it.
By doing so, you end up with a ton of evidence that supports your thesis but may leave out important information that could serve as a counterbalance to your original points.
The way to counter confirmation bias is to write down two columns on a piece of paper and actively search for pros and cons for any investment.
Force yourself to think of the worst-case scenarios and risks relating to a business and compile these into the list to serve as a dissenting voice.
Another method is to bounce your idea off a trusted friend and ask for his or her counterarguments so that you both don’t end up just agreeing with each other.
Overconfidence is another behavioural trap that can lead you to make poor investment decisions.
Being overconfident means you may not do sufficient research to justify your investment decision, relying instead on your “gut feel”.
It also means that you may leave out important risk areas or be blindsided by information you deem less important just so that you can go ahead and pull the trigger.
Overconfidence is more pervasive than we like to imagine.
In surveys conducted among college students and drivers, results showed that respondents were frequently overconfident about their prospects of getting a great job and driving without an accident, respectively.
To temper the incidence of overconfidence, ensure that you mentally account for all the risks of an investment and when in doubt, check and double-check.
4. Loss aversion
Loss aversion is a phenomenon where a loss is emotionally more severe than an equivalent gain.
This fear of experiencing loss may push the investor to behave irrationally and make hasty decisions that may impair his long-term investment performance.
Loss aversion works both ways in making investors sell too quickly.
If a stock is rising rapidly in price, for instance, blue-chip Keppel Ltd (SGX: BN4) which saw a 61% total return in 2023, the investor feels the urge to lock in the gain before it evaporates.
By doing so, he forgoes any chance of future capital gains should the business continue to do well.
The same problem occurs in reverse.
If a share price is tumbling, the investor may sell in a panic to prevent further losses even though the problem could be a temporary one, thus depriving himself of the opportunity to recover his capital.
5. Endowment effect
The endowment effect causes individuals to value an object they own more highly than its market value.
In other words, an emotional bond is created between the owner and the object, in what could be termed “sentimental value”.
This fondness may make investors “fall in love” with a stock they own and refuse to sell it even when business conditions turn sour.
The value they place on the company is higher than what is perceived by the market because of the endowment effect.
Having a clear investment strategy and a deliberate understanding of the securities they own can help to mitigate this effect.
By looking at your stocks objectively, you are in a better position to decide what to do with them without emotions creeping in.
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Disclosure: Royston Yang does not own shares in any of the companies mentioned.