Psychological Traps of Investing

There are 5 psychological traps of investing that an investor can fall into. There have been many extensive studies and articles done about the psychology of a person and when it comes to investing our hard-earned money we sometimes turn a blind eye to detrimental behaviours or we look to others for confirmation that what we do is best. These habits are all human and natural but can affect our investment strategies and overall our whole investment.

1. Anchoring Trap/ Overconfidence

Anchoring Trap is where you create a reliance on what you originally thought/believe.

For instance, you may originally think a company is great with amazing balance sheets and a good future ahead of it. You may be too confident that this certain stock is a good bet. Carrying this confidence forward over an investment period, the same stock may change. The balance sheet could worsen or turns out they aren’t performing as well as originally thought. 

Keeping the same faith in the stock/company, even after the fundamentals and potential future change could be detrimental to the long-term investment of your long hard-earned money.

Avoiding the anchoring trap isn’t easy to avoid. Studies have shown that some factors can reduce the effect of anchoring but overall it is difficult to avoid together. 

A good rule when it comes to investing and trying to avoid such a trap is to regularly recheck the investment. Run the investment through the same trial as originally done. If something has changed then it’s your duty to find out why and what it means. For many long-term investors, a reevaluation of investment offers every 3 to 6 months on average but this changes from person to person and is down to you how much of a close eye you want to keep on your investments.

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2. Sunk Cost Trap

Sunk Cost Trap is just as dangerous as overconfidence in an investment. This is where you psychologically protect your previous decision as it’s also human nature to not like being wrong! It’s hard to admit to yourself that you were wrong and accept that either you made a bad decision or allowed someone else to make them for you. Taking a loss both admitting a mistake and a monetary loss is difficult but if the investment is no good, or sinking fast, the sooner you get out and into a more promising investment the better. Limiting your loss before it starts to get rough can save you sleepless nights and a loss of hard-earned money.

If you had hung on to stocks bought at the dot.com heights in 1999 you would have had to wait a decade to break even once again. That’s a long time to take a loss when there were other well-performing assets. The Nasdaq market index rose 400% to fall 78%. Companies such as Cisco Systems declined 86%.

The Dot-com Bubble

3. Confirmation Trap/ Confirmation Bias

A confirmation trap is simply where you don’t want to be wrong, so you find someone who’ll back your decision. These people normally are those who have made and are still making the same mistake over and over.

An example of this could be where an investment within your portfolio drops by 40%. So you reach out to a friend who is in the same boat, you both own the same stock and both have losses. Reaching out to this friend they tell you that it’s okay, it’s a long-term hold and the best thing to do is to simply hold. Doing so both are sticking to confirmation bias as neither of you wants to be proved wrong. You comfort each other in the short term but it is self a delusion and potentially destructive over the long term.

A great way to beat this trap is to get advice from a fresh source, maybe also someone who isn’t in or stuck in the same boat.

4. Relativity Trap

A relativity trap is applying strategies which don’t suit your situation. There are many many ways to invest with no one strategy overall better than another. But there is always a strategy which suits you and will turn out best for you and your situation.

Everyone’s psychological make-up is different, combine this with unique circumstances such as work, family and prospects. This means you have to be aware of what others are doing and saying and see if these things apply to your goals and situation as what others are doing, saying their situation and views may not necessarily be relevant to you outside their own context. 

Make sure that the information you are receiving is relevant to your situation or investments, otherwise, it’s just noise.

5. Irrational Exuberance Trap

This term was popularized by former Fed chair Alan Greenspan in 1996. 

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Irrational exuberance is where the market has unfounded optimism and lacks a real foundation of fundamentals but instead relies on the psychological factors of investors.

This trap has been closely linked to the creation of inflated asset prices which are associated with market bubbles.

This normally comes from investors believing that the past equals the future and acting as if the market is certain, the market always carries uncertainty and will never fade.

We see commonly that we expect a 7-8% return from the overall market after inflation but this is far from the truth as this number is averaged out over many years. This means one year you could have a negative return from the market (Bear market) and in other years it could be significantly more than the average return of 7-8% (Bull market).

5 psychological traps of investing

It can be easy to create biases toward your own portfolio as you have put time and money into it. A good investor keeps track of their investments and any fundamental changes or news from companies. For this reason, ETFs are a popular option as less research and overall energy is needed to confirm that you are investing correctly.

If you are interested in ETF investing check out our article about why you may choose to put ETFs into your portfolio.

Why Choose ETFs in my Portfolio?

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