The Psychology of Investing: Understanding Behavioral Biases and Overcoming Them
What is key to not losing money in stock market or How not to lose money in stock market is often linked with psychology, believe it or not. When investing, there are two basic aspects that one might need to understand to make more conscious investment decisions. Firstly, one needs to understand the marketing trends and how the stock market works. Secondly, a rather underestimated aspect of the investment process is understanding the psychology of the investors. Combining both of these will make your investment strategy more efficient and earn better returns.
Below are some of the psychological biases that would directly affect the investors mindset and their investments strategies.
Experts of behavioral finance often use a term called confirmation bias which refers to the phenomenon of the investor being very stringent about their existing notions. In such a situation, investors have a fixed notion and they look up information and strategies which fit those notions. In this process, those investors end up ignoring data which goes against their ideas, no matter how appropriate and beneficial it might be. Bias investors not only seek information that fits their ideas but also interpret market movement accordingly. Moreover, their current investment strategies reflect their past experiences. These biases that reinforce their ideas affect the investors strategies and how they view the market.
Most investors have the tendency to have this bias because of a couple of reasons; being comfortable in what they already know and not having to make the effort to research, boosting their self-esteem of being ‘right’ and avoiding contradiction-induced stress. There are many setbacks that the investor might have to suffer from as a cost of this mindset. An investor might miss out on some really rewarding investment opportunities that may not fall under their idea of financial planning, not diversify their investment portfolio and increase the risk factor of their investments and might also end up buying shares which are more expensive than their real value.
HOW TO OVERCOME THIS BIAS: The first step to overcome this kind of emotional investment is to acknowledge its existence. The second step is to look for contradictory opinions and consider them with an open mind without unnecessary criticism.
Behavioral finance gurus talk about loss aversion as a concept where the investors do not take risks of investments due to the fear of a loss. This is because investors only consider a loss which happens after the deal is locked; not the one they have to suffer from by not taking up the right opportunities. The psyche of loss aversion, according to finance experts, can take up many faces including investing guaranteed but low profit deals, not selling stocks when you’re facing a loss when withholding them and selling stocks at minimal profits assuming profits won’t go higher.
HOW TO OVERCOME THIS BIAS: To avoid suffering from huge losses due to the fear of loss aversion, the investor needs to know that this bias is nothing but a weakness. One should not take financial losses, emotionally. Risks should be taken and they are beyond human control. Some measures can be taken to gain more trust on your investments like investing in low-risk deals, investing in government bonds or maybe adding variety in your investment portfolio to balance losses.
Whenever an investor is making a decision regarding where to invest, the first thing to consider is to realize that you will have your own goals and your own time frame for returns which might not match the others. Investors who have the herding bias, miss out on this step and tend to follow the crowd when investing. Instead of following your own rational analysis, the investor gets influenced and does whatever people are doing in the market which can be quite hazardous when it comes to making investments. The biggest drawback of herd mentality is that the crowd can magnify trends beyond a healthy amplification. Also, on an individual level, an investor might just pile up on stocks because everyone else is buying them, despite going into a loss.
HOW TO OVERCOME THIS BIAS: Although it is human nature to be a part of the crowd but it shouldn’t be at the cost of your monetary loss. The best way to avoid being prey to such emotional investment is by adopting the contrarian strategy which involves doing the opposite of what the crowd does; selling off the stock when everyone is buying them at high rates and vice versa.
The concept of anchoring bias in behavioral finance is the investor stringently sticking to the first piece of information and discarding all the information that they come across later. Anchoring bias is one of the primary reasons for wrong financial moves by consultants or investors themselves. They might end up buying an overvalued stock or sell an undervalued one. The most common case of anchoring bias is buying a share, bond or some funds and holding on to them despite the investment translating into a loss.
HOW TO OVERCOME THIS BIAS: Though it is impossible to completely get rid of this bias, it can be controlled to a certain extent. To do so, the investor should make a conscious effort to receive the information he/she comes across later on and do a conscious analysis.
This bias stands opposite to most of the forms of emotional investments that we have discussed earlier. Overconfidence bias is being too confident in your knowledge and decisions and taking massive risks leading to poor financial decisions. Investors often poorly assess their ability or talent to understand the market trends and the ability to build an investment portfolio accordingly. Though the fear of making wrong decisions is generally not a good thing, however, when it comes to investing, it could save you from many monetary setbacks as it will lead you to making conscious moves after in-depth research. Overconfidence bias takes the shape of multiple mindsets like rating your own performance more than what it deserves, thinking that you’re in control of the situation, assuming that investments will pay off in a certain time and also wishfully thinking about your returns.
HOW TO OVERCOME THIS BIAS: There are certain factors that if you, as an investor, consider, you might be able to get over the overconfidence bias. Some of them include having an open mind towards other people’s opinions, analyzing your mistakes and considering and working around the consequences and the feedback.