Understanding Investor Psychology

One of the biggest pitfalls when it comes to investing isn’t the market, but rather your perception of the market.  In order to ensure you make the wisest decisions possible when it comes to where you invest your money, we’ve made a list of some of the common psychological blind spots relating to investor psychology and how to avoid them.

Remain flexible in your thinking

Don’t be overly tied to or reliant on your initial thoughts. Just as you would be willing to reevaluate your opinions about politics and current affairs, you should be open minded when it comes to your investments. Even if such-and-such a company was successful two years ago doesn’t mean they’re still a good investment choice now. If you invest in a company based on nothing more than your own preconceived notions, you’re setting yourself up for failure. Be open to learning new things, and never forget that no company is bulletproof when it comes to the stock market. Even the bigwigs like Apple and Facebook have vulnerabilities.

Don’t cling to sunk costs

Keep on top of your investments and look for signs of a potentially dangerous stock. As soon as you see indisputable signs that an investment is sinking dangerously, re-evaluate whether you really believe holding onto it is a good idea. It’s hard to accept that you’ve made a bad investment, but it’s even harder in the long run to deal with the fact that you’ve stubbornly held onto a bad investment for too long and wind up losing even more.

Wilful blindness can be just as dangerous as being in denial – if you pay attention to your investments and stay up to date on stock market trends, there’s a good chance you can avoid dealing with too many sunk costs.The faster you can get rid of a bad or sinking investment, the better it will be for you (that being said – don’t panic and sell what is, in essence, still a good stock if the stock markets go down).

Avoid confirmation bias and herd instinct

Don’t talk yourself into believing a dubious investment is a good idea by seeking out others who have done the same thing. Trying to find comfort by rationalizing your investment decisions with other investors who are in the same boat makes sense from a psychological point of view, but not from a financial one. Get objective advice from people who don’t have the same emotional ties to the stock that you have and make decisions based on that.

The same concept applies to ‘herd instinct’ or ‘the herd mentality’ in which we see a large majority of other people doing something (in this case, investing in the same stock or industry) and think we should do it too. Make decisions based on objective fact, not ‘well everyone else is doing it so I should too’. Herd mentality can be dangerous at the best of times, so are you really going to trust it when it comes to something as important as your money?

Get other people’s opinions and don’t overestimate your own abilities

Overconfidence is one of the biggest causes of financial ruin when it comes to the stock market. Hubris can a dangerous trait, and when you add money to the mix, the situation easily become dire. Even the most educated people can make bad calls when it comes to investing, and believing you can somehow ‘outsmart the market’ is a surefire way to lose a lot of money in the long run. An investor who overestimates their own ability will also be likely to underestimate forecast errors.

Be patient and focus on long term goals

Don’t panic if your investments dip or the market looks shaky. Chances are, it’s temporary (and if it’s not, then you’ll be able to make a proactive decision about whether you want to hold on to your stock or not by continuing to pay attention to trends). Rather than focusing on short-term gains and losses, pay attention to the bigger picture. Base your decisions on long-term goals (because obsessing over short-term events will cause nothing but unnecessary stress and result in bad decision making).