Human psychology and investing
Add all those together, and you become even more likely to be wrong, kind of like tossing a coin one time and getting heads, but then tossing it so many times that you will ultimately get a lot of tails too. If I buy stock X at point A, its price can go up or down soon after my purchase.
If I then sell stock X at point B, it can go up or down after I sell it. If I wait until point C, it can also go up or down. Each time I make a decision, I collect errors along the way. If investment decisions are error-prone, then try to make fewer decisions. In the aggregate, individual investors who buy and hold in trusted companies are more successful in the long term than those who buy and sell often.
The more they learn their stuff, the less they are guessing. So know your stuff or ask an expert. A stock ticker is just the name of a company. So why would you buy a tiny piece of a company knowing so little about it?
Every respectable brokerage firm provides its clients with a plethora of expert information, statistics, and detailed analyst reports. Read the news about it, especially why its stock is going up or down before you click any buttons. Where there is knowledge, there is less error.
Anxiety bends to reason, so you will feel less jittery too. You will have rational reasons for your final conclusion to buy, sell, or hold. So even if you were off, you will at the very least have less cause to berate yourself. After you do your research, trust your research Ask yourself, do you believe in this company? You are giving your money to a company to grow its business. Do you like their business and do you want it to expand? Do you think the company will utilize your hard-earned money wisely?
It is not yours till it is cash This is perhaps the trickiest thing of all, psychologically. But really, you do not own the dollar signs unless you no longer own the stock. You lent it to the company, remember? It can be a calming influence to train yourself to convert dollar signs to votes of confidence.
This can help you reframe wild fluctuations of opinion in companies you believe in. To acquire a more long-distance vision, try looking at the entire trajectory of known winners, from IPO to today. Look at Amazon, for instance. The company took forever to become profitable. The world was slowly becoming his oyster, while his stock was in the gutter. Talk about error. Naturally, diligent investors keep an eye on abnormal fluctuations and events that can rattle economies.
Unlike irreplaceable losses, the beauty of money is you can make it up with better decisions in the future. Learn from your mistakes by following stocks long after you sold them or failed to buy them. Finally, have some cash on hand to scoop up opportunities when the market swoons.
Remember when a mini panic grips the market, many stocks go down, including in the portfolios of pro investors like Graham and Buffett. Overconfidence Bias Overconfidence is an emotional bias. Overconfident investors believe they have more control over their investments than they truly do. Since investing involves complex forecasts of the future, overconfident investors may overestimate their abilities to identify successful investments. In fact, experts often overestimate their own abilities more than the average person does.
In a study , affluent investors indicated that their own stock-picking skills were critical to portfolio performance. In reality, they had overlooked broader influences on performance. At its most extreme, an overconfident investor can become involved in investment fraud.
Economist Steven Pressman identifies overconfidence as the primary culprit responsible for the susceptibility of investors to financial fraud. Self-attribution Bias Self-attribution bias occurs when investors attribute successful outcomes to their own actions and bad outcomes to external factors. This bias is often exhibited as a means of self-protection or self-enhancement.
Investors with self-attribution bias may become overconfident, which can lead to underperformance. To mitigate these effects, investors should track personal mistakes and successes and develop accountability mechanisms. Active Trading In many studies, it has been shown that traders who trade excessively active traders actually underperform the market. In a study conducted by Professors Brad Barber and Terrance Odean, investors utilizing traditional brokers communicating via telephone achieved better results than online traders who trade more actively and speculatively.
In another of their studies Barber and Odean analyzed 78, U. After segmenting the group into quintiles by monthly turnover rates in their common stock portfolio, they found that active traders earned the lowest returns see table below. They found investor overconfidence to be an important motivation for active trading.
Loss Aversion Established financial efficient market theory holds that there is a direct relationship and trade-off between risk and return. The higher the risk associated with an investment, the greater the return. The theory assumes that investors seek the highest return for the level of risk they are willing and able to take on. Behavioral finance and related research seem to indicate otherwise. Some estimates suggest people weigh losses more than twice as heavily as potential gains. Even though the likelihood of a costly event may be miniscule, people would rather agree to a smaller, sure loss than risk a large expense.
Disposition Effect As a result of their fear of loss, investors often hesitate to realize their losses and hold stocks for too long hoping for a recovery. Both individual and professional investors do this across assets, including common stock options, real estate, and futures.
Portfolio Construction and Diversification Framing According to the modern portfolio theory , as developed by Nobel Prize winning economist Harry Markowitz, an investment should not be evaluated alone, but rather by how it affects the portfolio as a whole. Rather than focusing on individual securities, investors should consider wealth more broadly.
In practice , however, investors tend to become hyper-focused on specific investments or investment classes. Mental Accounting The human psyche tends to bucket or categorize types of expenses or investments mentally. Oftentimes, mental accounting leads people to violate traditional economic principles. L went on a fishing trip in the northwest and caught some salmon.
They packed the fish and sent it home on an airline, but the fish were lost in transit. They had never spent that much at a restaurant before. According to Thaler, this example violates the principle of fungibility in that money is not supposed to have labels attached to it. Investors tend to focus less on the relationship between investments and more on individual buckets, not thinking broadly about their overall wealth positions.
Investors also prefer domestic investments over international investments. An implication of familiarity bias is that investors hold suboptimal portfolios and suffer from under-diversification. To overcome this bias, investors need to cast a wider net.
Misuse of information Anchoring Investors tend to hold onto a belief and then apply it as a subjective reference point for making future judgments. People often base their decisions on the first source of information to which they are exposed such as an initial purchase price of a stock and have difficulty adjusting their views to new information.
In fact, round numbers such as 5, points on the FTSE Index often attract disproportionate interest. Representativeness Bias When investors exhibit this bias, they label an investment as good or bad based on its recent performance.
As a result, they buy stocks after prices have risen expecting those increases to continue and ignore stocks when their prices are below their intrinsic values. People tend to think in terms of past experiences, arriving at results too quickly and with imprecise information.
For example, if a company announces strong quarterly earnings, an investor with this bias might be quick to assume the next earnings announcement will be strong as well. Investors often want to impose a sense of order on things that are actually random.
The phenomenon is named after gamblers who believe that a string of good luck will follow a string of bad luck in a casino. In the context of investing, this bias can lend unfounded credibility to the claims of fund managers who have been successful for a few years in a row. It can also cause investors to perceive trends where none exist, and to take action on these erroneous impressions.
Attention Bias According to traditional financial theory, buying and selling an investment should be two sides of the same coin. That is, in theory, investors observe the same signal when deciding to buy or sell.
However, a study posits that individual investors are more likely to buy rather than sell those stocks that catch their attention e. This is because investment purchasing requires investors to sift through thousands of stocks, but investors are limited by how much information they can process. Sometimes, the attention-attracting qualities of an investment may end up detracting from its utility. For example, a well-circulated article about a deserted vacation spot could attract the attention and the travel plans of vacationers, each of whom would be disappointed by the crowds of like-minded vacationers.
Source: Baltimore Sun Beyond Trading Psychology: Cultural Differences in Investing Economists have traditionally assumed that biases are universal , ignoring how other drivers might also shape financial decision-making. Up until this point in the article, we have primarily discussed psychological factors, which is more focused on the individual. However, there is growing evidence that preferences are also shaped by external factors such as society and culture.
Cultural finance , an emerging research field, studies just this. Both behavioral finance and cultural finance reject traditional notions of pure rationality. This section delves into the differences in investing tendencies across global cultures, including differing levels of loss aversion, patience towards investments, approaches to portfolio management, and more. Defining Culture Perhaps the most famous definition of culture comes from Dutch sociologist Geert Hofstede, who dictates culture as a collective mental programming of the mind which is manifested in values and norms, but also in rituals and symbols.
Hofstede breaks culture down into five dimensions as seen below. Since cultures emphasize these dimensions to varying degrees, the following analysis examines how certain cultural dimensions and idiosyncrasies contribute to different investing tendencies. Mei Wang, Dr. Marc Oliver Rieger, and Dr. Thorsten Hens examined the time preferences, risk behavior, and behavioral biases of nearly 7, investors in over 50 countries.
After controlling for factors such as national wealth and growth, they found that Anglo-Saxon countries are the most tolerant of loss, while investors in eastern Europe have the greatest loss aversion.
0 comments