This is a guest post from Tim Richards, whose Psy-Fi blog is all about psychology and finance. It was first published here in the depths of the bear market in 2009. I thought it’d be fun to showcase it again on the eighth anniversary of those lows, with markets now giddy at all-time highs! People don’t change…
Making money from stocks is easy enough if we can defeat the main enemy – ourselves. There’s no getting around the fact that us humans are subject to lots of biases and psychological quirks that combine to destroy our investing returns.
The first line of defence against this is to recognise the problem.
Here are seven psychological quirks to look out for.
1. Overconfidence and optimism
Most of us are way too confident about our ability to foresee the future, and overwhelmingly too optimistic in our forecasts.
This finding holds across all disciplines, for both professionals and non-professionals, with the exceptions of weather forecasters and horse handicappers.
Lesson: Learn not to trust your gut.
2. Hindsight
We consistently exaggerate our prior beliefs about events.
Market forecasters spend a lot of time telling us why the market behaved the way it did. They’re great at telling us we need an umbrella after it starts raining as well, but it doesn’t improve our returns. We’re all useless at remembering what we used to believe.
Lesson: Keep a diary, revisit your thinking constantly.
3. Loss aversion
We hurt more when we sell at a loss than we feel happy when we sell for the same profit. But stocks don’t have memories – decisions on whether to buy or sell should always be independent of your buying price.
Lesson: Ignore buying prices when deciding whether to sell.
4. Regret
Investment decisions should overwhelmingly be about risk, and risk implies a judgement, which may turn out to be wrong, often through bad luck rather than bad thinking.
Becoming overly focused on past decisions that have gone wrong without analysing whether the decision made was rational under the circumstances isn’t rational. Investing involves making mistakes and is often down to luck.
Lesson: Learn to live with mistakes.
5. Anchoring
Ten years or more of research has shown we have a nasty tendency to ‘anchor’ on specific numbers. Psychologists can change the results of simple estimation questions (for example, how old do you think Woody Allen is?) simply by posing an earlier unrelated question containing a number.
Lesson: Don’t get fixated on specific numbers, such as buy prices, stop loss prices, or index values.
6. Recency Bias
We pay more attention to short-term events than the longer-term. So the effect of a short-term downturn in a company’s fortunes may be exaggerated, or we may simply assume that current market conditions will persist forever.
Lesson: Buy some history books, and look beyond the short term.
7. Confirmation Bias
We just love other people to confirm our decisions. And other people just love us confirming their opinions. In fact we could just get together and have a regular love-in but it doesn’t make for good investing. The only money you lose is your own.
Lesson: Make your own decisions; don’t worry about what others think.
Special bonus quirk!
As a bonus investment quirk, my all-time favourite is Myopic Loss Aversion. This is where investors can’t stand the sight of red ink in their portfolio – they avoid short-term losses at the expense of long term gains.
Such people should be physically restrained from buying shares. Let them play checkers with five-year olds or something they can always win at.
Conclusion
Many people who invest heavily in shares tend to heavily exaggerate their own abilities and downplay the role of luck in stockmarket investment. Sadly there is a lot of random stuff in the market which we can’t control.
The easiest way of managing these psychological ticks is to invest regularly and for the long-term in index trackers and avoid selling no matter what the circumstances.
Failing that – go take a course in weather forecasting. At least you’ll be more help than most market forecasters who can only tell you that you need an umbrella after it starts raining.
P.S. Woody Allen is 81. Most of you will have thought lower, unless you really knew the answer.
Tim Richards has written a book – The Zeitgeist Investor – which is all about what happens when our brains and the stock market collide.
Thanks for reminding me of the Psy-Fi blog – one of my all time favourite sites (apart from this one !) and all good advice and even more essential at giddy all time highs ..
Special bonus quirk!
Laughed out loud at that one. Recent AXA portfolio has red in bonds and emerging eq. and has been a cause of furrowed brow despite the portfolio doing well as a whole. Timely warning.
I liked that post. One thing he didn’t mention, and we often see here, is that people hate to sell anything. They get so ingrained in building their pot that when they FIRE they can’t bear to part with it. Many people like their High Yield Portfolios, and feel that you must live on dividends for their Safe Withdrawal Rate, and never touch the capital. This means they miss out on a range of equity focussed on capital growth, and pay tax on the dividends when they wouldn’t on the capital gain.
“invest regularly and for the long-term in index trackers and avoid selling no matter what the circumstances”: that’s one way to discipline yourself and I dare say it will often work well enough. It’s incompatible, though, with the doctrine of rebalancing your portfolio which might require you to sell occasionally.
How about a couple who have reached retirement and want to know how to ensure that they don’t exhaust their pot before the second of them dies? Is there an equally useful rule of thumb?
–“This is where investors can’t stand the sight of red ink in their portfolio “–
I’m rather the opposite, especially over the last year. I always get a bit nervous when shares shoot up like rockets and this year, the gains are all so sky high, it’s made me nervous about where to invest my ISA cash. I still have some EM ETFs that haven’t moved much and are paying huge dividends, so will concentrate on those.
-” and feel that you must live on dividends for their Safe Withdrawal Rate, and never touch the capital. “- Hi John, yes, I agree to an extent, but it also depends on their broker and how much they plan to sell. If taking capital, you have to factor in the dealing charges and buy-sell spread. Dividends just arrive in the bank account with no added expense.
Recency bias: just before the brexwit vote, I held my investment nerve in not changing anything and then took the loss on currency devaluation in more than one asset class by trying to ignore my gut feeling that crashing out of the EU wasn’t fully priced in.
Now though, I’m shifting what I have in cash into what I hope is a basket of safer currencies, so that if the £ dives again after T. Maybe presses the button I can buy it back cheaper. Call this one ‘chasing your losses bias’; or I don’t know what you think of it as when you know full well you’re doing something that could be dumb. My only mitigation is that I can afford this calculated level of experimentation, like a conscious night out intending to splurge-type indulgence 🙂
@FI Warrior
“took the loss on currency devaluation “….” I’m shifting what I have in cash into what I hope is a basket of safer currencies, ”
See Recency Bias point 6, Regret point 4
Having a diversified portfolio, in multiple currencies is a pretty good starting point for most investors, the pound fell but I would not attempt to speculate whether the next move is up or down, professional currency traders don’t do very well and with respect an amateur is not likely to do no better.
I have seen significant appreciation in sterling terms in my portfolio and there is a temptation to try and ‘lock’ these gains into sterling on the basis that the pound goes up and down all the time and there may be a significant bounce back, but I know my judgement as regards timing of such moves is in fact no more than guess work and consequently I will leave my portfolio as it is.
( I started with slightly more UK assets than my long term allocation plan calls for and this prevents me from rebalancing back to my allocation target)
Elites hate this trick that shows seven psychological quirks that destroy investment returns!
Just kidding, listicle-y title aside, I found The Zeitgeist Investor to be a solid read, worth spending a few hours on.
@L — Yes, that title is a relic from my three-week long era of trying to actually get some worthwhile traffic to the blog via clickable titles. (You laugh, but the vast amount of traffic that has since been syphoned away from *cough* quality blogs over the past 10 years is incredible; it’s had a huge impact. Everyone laughs at Buzzfeed, and the Daily Mail’s skyscraper of bikinis or whatever it’s called, at Facebook trivia, and then spends all their time and their clicks on them. 🙁 There are small signs the tide might be turning though).
But we’re off-topic, so let’s leave it there! 🙂
Apologies – still off topic but .. the tide may be turning on funding blogs amongst other things – subscriptions are starting to take off apparently .. (via @ftalphaville) https://www.nytimes.com/2017/03/15/technology/how-the-internet-is-saving-culture-not-killing-it.html?_r=1