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The most common investor mistakes and how to avoid them
Investing can be a powerful tool for building wealth, but it is also an area full of pitfalls. Many of these pitfalls stem from our own human psychology.
In this article, we discuss the most common investor mistakes and offer practical tips for avoiding them.
Introduction to Behavioural finance
Behavioural Finance is an economic theory that attributes the irrational behavior of individuals making financial choices to psychological factors or biases. The latter can often explain all types of market anomalies and specific behaviors of financial markets. The theory came about as a response to the efficient market hypothesis (EMH) which states that - in a highly liquid market - all stock prices are efficiently valued based on all available public information. However, many studies have documented historical long-term phenomena in financial markets that contradict the EMH and cannot be credibly represented in models based on perfect investor rationality. In general, theories of "behavioral finance" have also been used to provide clearer explanations for major market anomalies such as bubbles and deep recessions.
Emotions and prejudices are a poor counsellor. Consequently, it is important to be aware of these emotions and to know and avoid common thinking errors.
Emotional pitfalls
1. Overconfidence: The illusion of control
Many investors tend to overestimate their own abilities. They think they can beat the market when the reality is different. The belief that you can control the results when you cannot, creates a certain overconfidence.
Example: An entrepreneur who is successful in his business may mistakenly assume that this success automatically translates to success in investing.
How to avoid:
- Set realistic goals, behave accordingly and accept that markets are unpredictable.
- Inform before you start investing and continue to invest in better information, education and advice.
2. Loss aversion: fear of loss
Loss aversion or "loss aversion" occurs when investors place a greater weight on worrying about losses than on enjoying market gains. In other words, they are much more likely to try to place a higher priority on avoiding losses than on making investment gains. After all, losing hurts more than winning.
This can lead to irrational decisions, such as holding on to poorly performing investments for too long in hopes of recovering losses.
When we apply loss aversion to investing, we see the so-called disposition effect in which investors sell their winners and hold their losers, regrettably a common investor mistake.
Example: An investor refuses to sell a poorly performing stock despite clear signs that the outlook is bleak. And this purely because he does not want to realize the loss.
How to avoid:
- Set clear selling rules in advance: If negative issues come to light at a company that were not known at the time of your purchase decision, have the courage to sell.
- Dare to admit to yourself that you have made an investment mistake. Don't stare blindly at your own entry price , it is often misused as an anchor point.
3. Herd behavior: running with the crowd
It is tempting to follow popular trends, especially when you hear and read that "everyone" is investing in a particular sector or stock. However, this can lead to buying at the peak and selling during panic moments. It is notorious in the stock market as the cause of dramatic bubbles and subsequent crashes. Super investor Warren Buffett puts this nicely, "be fearful when others are greedy and greedy when others are fearful."
Example: During a hype, such as the technology bubble in 2000, many investors get in without understanding the underlying value of the assets.
How to avoid:
- Do your own research and understand what you are investing in.
- Put together a diversified portfolio that matches your risk profile and goals, not those of others.
4. Short-term thinking and emotional decisions
Declines in short-term prices can lead to panic selling, while sharp increases can lead to overconfident buying.
This market volatility can trigger emotions such as fear and greed, leading to irrational decisions. Fear can keep you from investing, while greed can spur you into risky speculation. Investors who are overly focused on the short-term have a higher risk of making emotional decisions. Stock market movements are totally unpredictable in the short term, while in the long term they do move with economic growth and inflation rates.
Example: An investor sells his shares during a temporary market downturn, even though he had set long-term investment goals.
How to avoid:
- Set a long-term plan and stick to it regardless of daily market fluctuations. Make decisions based on facts and strategy, not emotions.
- Don't review your portfolio too often; once a quarter is often sufficient.
- Automate your investments through a periodic investment plan.
Cognitive pitfalls
In addition to emotional pitfalls, there are cognitive pitfalls, which result from errors in thinking. In theory, they are called biases or "biases. The most common are:
1. Confirmation bias: looking for what you want to hear
Investors tend to seek information that confirms their existing beliefs and ignore contradictory information. This can lead to tunnel vision and poor investment decisions.
Example: Someone who believes that technology companies will always grow ignores warnings about overvaluation and economic risks.
How to avoid:
- Actively listen to different points of view and seek counterarguments.
- Consult an independent financial advisor to identify blind spots.
2. Hindsight bias: I knew it!
Hindsight bias is the tendency to believe that you could have predicted the outcome of an event after it has already occurred. This can lead to hubris and poor future decisions.
Example: After a stock market drop, an investor says, "I knew this would happen," while taking no action beforehand.
How to avoid:
- Keep an investment journal in which you record your decisions and the reasons for them.
- Reflect on your mistakes without regarding the outcome as "inevitable."
3. Self-attribution bias: attributing success to yourself
Self-attribution bias means that investors attribute their successes to their own skill, while they attribute setbacks to external factors or bad luck rather than incompetence. This can lead to overconfidence and a lack of self-reflection.
Example: An investor who profits in a bull market thinks it is because of his smart decisions, while the market as a whole is just performing strongly.
How to avoid:
- Evaluate your results in the context of the market as a whole.
- Actively seek feedback and be honest about your performance.
4. Framing: the way information is presented
The way information is presented can influence investment decisions. Positive framing can make investors overconfident, while negative framing can lead to unnecessary caution.
Example: A consumer is more likely to choose yogurt that is 80% fat-free than the same yogurt that contains 20% fat, even though both mean the same thing.
How to avoid:
- Analyze figures and information objectively, without being influenced by the presentation.
- Ask for additional data if information seems too one-sided.
5. Lack of diversification
A portfolio that relies too heavily on a particular investment strategy, sector, region or asset class is more at risk. Diversification helps spread this risk.
Example: An entrepreneur invests only in real estate because he is familiar with it, ignoring other options such as stocks or bonds.
How to avoid:
- Spread your investments across different sectors, regions and asset classes.
- Add assets or strategies that do not follow a benchmark or follow less of one.
Conclusion: take control of your emotions
Investing is not just about numbers and analysis; it is also a mental challenge. By understanding the principles of "behavioral finance" and being aware of your own pitfalls, you can make better decisions and increase your chances of success.
Summary Tips:
- Acknowledge your own limitations and be aware that your humanity can affect your returns.
- Invest for the long term and ignore short-term fluctuations. It is not the timing of the market, but the time in the market that plays.
- Avoid emotional decisions through a disciplined approach or be guided for most of your assets.
- Diversify your portfolio and stick to your strategy.
Successful investing requires discipline and self-reflection. By being aware of how psychology affects your decisions, you can avoid pitfalls and pursue your investment goals with greater confidence.
If you can't manage to control your emotions, think in time to hire an outside consultant such as Value Square.
Author: Petrick Step
For more information: info@value-square.be
