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The Psychology of Investing

November 27th, 2017 | Written by

The Psychology of Investing

 

The increased volatility in the market has many investors feeling as though they are on an emotional roller coaster. Investors may think, “The market tanked, I should have seen it coming”, or, “my account is down, but I don’t want to sell at a loss”. These thoughts are from people struggling to separate their emotions from their investment decisions. While overcoming your own thoughts can be difficult, understanding the psychology of investing, knowing what causes behavioral biases and how they affect your investment decisions can help keep your emotions in check.

Recency Bias – This is when investors believe that current events will last forever and predict the future based on what has recently occurred. If the market is performing poorly, investors might mistakenly believe this will continue forever. Perhaps when the market is doing well, they might forget about the inherent market volatility and believe it will continue to go up. It is important to keep a long-term perspective and remember that changes will occur. Consider this – you wouldn’t drive while only looking through the rear view mirror. Investing is much the same, while it may be valuable to look into the rear view every once in a while, you need to keep your eyes on the road ahead to stay on track.

Choice Paralysis – Have you ever caught yourself at a store trying to pick out an item only to find yourself overwhelmed with choices and leaving with nothing but frustration? When investors are offered too many choices, they may feel the same way. This may hinder their ability to make an informed decision and invest. Don’t be intimidated by choices! By utilizing proper tools to help screen your choices, you can make an informed decision and invest.

Herding – Did your parents ever ask you, “if all your friends jumped off a cliff, would you follow?” The same statement can be said to investors who are prone to the herding bias. This is the tendency of investors to follow the actions of a larger group. Buying all the same investments and following what everyone else is doing provides us with a sense of safety. By the time most investors meet-up with the herd, the trend could very well be over. Remember the dot-com stock crash in the late 1990’s? Investors were hurt by following the herd.

Loss Aversion – This is when investors are more sensitive to losing money than to gaining money. It is important to understand that with investments come risk. A long-term investor will see the market fluctuate throughout their life – don’t sweat the losses and focus on the future.

Confirmation Bias – This is the tendency to only look for information that supports your ideas. If you think a particular stock is going to do well, you only read articles that reaffirm your ideas. Investors need to look at various sources so they are looking at the whole picture.

Optimism & Overconfidence – When an investor’s portfolio is doing well, they might become overconfident and think they are invincible, which may lead to excessive risk taking. Any investment decisions should be analyzed fully to reduce poor investment decisions.

Bias Blind-Spot – Investors believe that none of these behavioral finance biases could happen to them. The reality is, we’re only human! Every investor experiences some, or all, of these biases at some point. Remember, having a sound financial plan, and sticking to it, can help you avoid behaving emotionally and becoming susceptible to investor biases.

Identifying these psychological responses can help you keep your emotions in check – it may even make you a better investor.

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