The book The Psychology of Investing, by John R. Nofsinger, sheds light on some of the reasons we make mistakes in the market, and why we may continue to make the same investing mistakes over and over again.
1. We’re Predictably Irrational
The bad news is that humans often act irrationally. The good news is that we’re consistent in how we act irrationally.
People get in their own way through various cognitive biases and errors, which are predominantly the result of self-deception, mental shortcuts, the influence of social networks, and their current emotional state.
2. We Misjudge Ourselves
People are deficient when it comes to self-assessment. We make faulty estimations and have unrealistic self-perceptions.
People, retroactively, tend to attribute positive outcomes to internal factors, while blaming negative outcomes on external factors.
According to The Psychology of Investing, when we believe we’re in control, which is often an illusion, we’re willing to take more risks.
People overestimate, more generally, how much they know and, more specifically, how accurate their information is.
3. Pride & Regret Pull Us Off Course
Pride leads to selling investments that are performing well too soon, whereas regret convinces us to keep poorly performing investments too long.
4. Experiences Affect Risk Tolerance
Investors tend to take on more risk with their “investment profits” than with earned money.
We frequently become less willing, sometimes unwilling, to take on risk after realizing a large loss.
5. Our Internal Accountant Should Be Fired
People forget or fail to calculate (and therefore don’t take advantage of) the time value of money.
Mental compartmentalization can stunt efforts to diversify a portfolio or lead to inaccurate assessment of risk.
6. We Preference the “Home Team”
People assign more value to things they own and brands or companies they’re familiar with. We also have a tendency to confuse good products with good investments.
The psychology of investing helps us understand why people are compelled to invest in “hot” stocks. They overlook the ever-increasing price based on the assumption recent trends will continue. The fear of loss is replaced by the fear of missing out.
7. We View Amateurs as Experts
People have a knack for looking for advice in all the wrong places. We hear tips on social media, from our friends, and at events. We preference advice from those we perceive as similar to ourselves (based on age, education, socio-economic status, etc.). Social influences sometimes lead to pack mentality which, in turn, can create bubbles.
8. Our Mood Matters
When there is greater uncertainty, people’s decisions are more emotionally driven. When it’s sunny outside, we’re more willing to take risks. When our disposition is sunny, our assessments are less likely to be driven by data.
Bonus – We Lack Willpower & Restraint
Many investors who attempt to focus on long-term success get pulled back into thinking short-term. This is, in part, the result of the brain’s “reward wiring”. We want to do things that will bring pleasure now, and put off those things that are less pleasant.
Beat the Biases!
We can overcome many of our mental barriers through:
Awareness – Learning more about the ways our mind can play tricks on our perception.
Reminders – “Hot tips come too late!”
Environmental Design – Automate your investments.
Written Criteria – What makes a good investment? Does this one measure up?
Goals, Values, & Vision – Why are you investing? How will investment success shape your future?
With practice, patience, and a nudge here and there, we can all make more rational investments!
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