5 Ways the Psychology of Investing Tricks You

It’s comforting to imagine that investors are highly logical creatures whose money-centric decisions are made with an abundance of rational consideration alone. But the truth is, a great deal of emotion is in play when we contemplate where to invest our bucks.

According to BMO Financial Group’s most recent Psychology of Investing Report, only one in three investors relies completely on research, and just 28 percent report being in control of their emotions at all times. For those who do allow emotion to figure into their investment decision-making, optimism, anticipation and confidence are the feelings that most commonly come up.

Broadly speaking, a variety of identified dysfunctional psychological influences regularly encourage investor behavior to leave logic in its dust. From individual personality traits to fatigue to the impact of the weather, emotions simply have a lot of sway for investors when it comes to decisions around their money.

Here are five emotional heavyweights that might threaten to knock your logic off track — and some advice on how to keep them in check.

1. Recent-Events Preoccupation

The power of recency is a biggie when it comes to those external influences that have dominion over our choices. Whatever just captured our attention, after all, naturally races to top of mind. More than that, if something happened once, we convince ourselves, it’ll likely happen twice. Find the adherents to this philosophy at the casino, stalking the slot machines that just delivered payouts with the conviction that they’re bound to do so again.

This approach to investing, where it’s also known as “chasing returns,” is best countered by a long view that considers not just top performers from the last four weeks, but from the last four years.

2. Myopic Loss Aversion

psychology of investing

Long recognized by psychologists exploring behavior motivation, this phenomenon refers to the short-sighted view to which anxious individuals with money in play are prone to falling prey. Here, investors become consumed with the coming minutes and hours, and put themselves at risk of making potentially foolish kneejerk decisions rather than waiting things out. These are the folks who sell stocks in a panic or linger too long on the outside of a poised-for-turnaround market slump.

For individuals prone to such thinking, it’s prudent to remember this: a return to the mean is inevitable. Patience is a virtue, after all. So sit tight, and lift your gaze.

3. Overconfidence

As much as your mom might have had you believe otherwise, you’re probably not nearly the hotshot investor you imagine yourself to be. Reckless money-shifting conducted under the influence of such unwarranted cockiness — men, research shows, are more susceptible to these overblown self-valuations than women — can deliver big losses.

A realistic assessment of one’s knowledge and abilities is essential in investing. That translates into steady, thoughtful investment decisions that are based on truth rather than fiction. And if you’re still struggling to rein in your sky-high confidence, force a worst-case mental scenario on your situation. If you lose it all, ask yourself, how will you survive?

4. The Herd Mentality

psychology of investing

It takes a lot of personal resolve to move in the opposite direction of the crowd. But sometimes you should. Celebrated investor John Templeton understood this maxim implicitly, and so removed himself from the reach of the prevailing winds by moving to the Bahamas during his management tenure of the Templeton Group.

In order to similarly avoid such all-consuming weather patterns, you need to focus your sights. Do your research, consider the uniqueness of your distinctive investment situation, and remain flexible to new sources of information – no matter how singular you may be in adopting them.

5. Sunk-cost Fallacy

There’s something primitive in the self-protective impulses that kick in when you’ve made a decision that’s tanking. Rather than cut bait, investors who are given to this psychological malfeasance keep right on fishing, imagining the lake will suddenly fill with cod.

But as hard as it is to accept that you made a bad decision, if your investment is or sinking, you must abandon it.

The thinking behind the sunk-cost cognitive bias is that people are trying to avoid the losses because it simply hurts too much to acknowledge them. But sustaining emotional commitment to bad investments is never smart.

Instead, consider that the money you’re sinking into the losing venture could be doing good work in a more lucrative opportunity. Plus, you can use capital losses to offset capital gains, and so cut your tax bill.

Human psychology is a complicated beast, and investors are just as likely to fall victim to its inherent weaknesses as the next guy — but it stands to cost them more. An awareness of these tendencies, however, is the first step in sidestepping them.

Have you made any of these errors while investing? Share your stories in the comments below.

psychology of investing

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