Investing can be an emotional process, and even the most level-headed investor will sometimes find themselves being swept up by the inevitable ups and downs of markets.
One of the best ways to make better decisions when it comes to growing your wealth over the long term is to understand the psychology behind investing. If you can recognise the common mistakes that human psychology makes us prone to, then you are more likely to make good decisions in the future and manage your emotions more successfully.
The most common mistakes (which psychologists call ‘biases’) can be grouped into four categories: ego, emotion, attention and conservatism.
1. Over-confidence (‘Ego’)
Many people overestimate their skills, whether it’s their driving skill or managing their own finances. In investing, overconfidence often leads to people overestimating their understanding of the stock market or specific investments. This may result in ill-advised attempts to time the market or build concentrations in risky investments.
Professional fund managers have one significant advantage – they are trained to understand the impact of biases and can attempt to mitigate the risks. That is why it is generally better to spread your investments across a wide range of expertly managed funds.
2. Letting feelings cloud your judgement (‘Emotion’)
The mood you are in dramatically influences the way that you see the world. All of us have a tendency to let our feelings colour our judgments of risk and reward, and to influence our decision-making process. People often become more optimistic and self-confident when markets rise, only to descend into fear and panic when they fall.
Avoiding the risk of over-reacting is key to long-term investment success. Investors need to be ready to manage their emotions when markets rise and fall. Taking personal financial advice can help you to contextualise what you’re going through. Also, automating a regular monthly payment into an investment plan can also help to remove emotion from the investing process.
3. Reacting to short-term noise (‘Attention’)
“Nothing in life is as important as you think it is, while you are thinking about it,” wrote the psychologist and economist Daniel Kahneman.
As investors, it can be all too tempting to try to react to events as they happen. That’s because our brains are hard-wired to confuse how striking an event is with how likely it is to happen.
For example, shark attacks capture the public imagination – thanks to movies like Jaws – and yet they are extremely uncommon. Real and insidious risks, like heart disease or diabetes, are much less sensational – and so we down-weight them.
The best investors do not seek to time the market by forecasting (or reacting to) short-term events. They know that uncertainty is what they are being paid for, and so they adopt principles for the long term. Such an approach may lack the excitement of responding to every news headline and market turn, but it will enable you to keep your eyes focused on the horizon. Regularly meeting with your financial adviser can help maintain those goals.
4. Playing it too safe (‘Conservatism’)
We are all hard-wired for safety. It enabled our distant ancestors to survive in times when resources were scarce. Today, this conservatism could lead you to avoid less familiar investment options and taking less investment risk than you should. Over a lifetime, this could cost you thousands of dollars.
‘Conservatism’ describes our asymmetrical fear of loss, versus our happiness about reward. Literature suggests that people are two-and-a-half times more upset by a loss than they are happy about a comparably-sized gain. So, if you are a gambler, winning $100 is no big deal. But if you lose $100, you’re pretty upset. We see this in the stock market too. Advisers get many more distressed calls when portfolios are down 20% than they do thank you letters when portfolios are up.
Regularly meeting with your financial adviser can help you to manage your emotions and make informed investment decisions.