January 2019
THE PSYCHOLOGY OF INVESTING
Investing is not just a matter of having the best strategy and finding the best investments to use.
It is common knowledge that much of the success of investing is a matter of mastering the psychology of investing. Here are some common challenges that investors struggle with on the path to financial success. The problem is that our brains are wired to avoid pain and seek pleasure. Thus, we tend to move towards whatever feels to be immediately rewarding. This is often the wrong move. For example, when the market is in a downward move, it may make our emotions feel better to get out to avoid the pain of lower markets. Conversely, when the market is moving upward, we tend to want to buy into the trend, so we don’t “miss out”. Both these may be the wrong move for the right reason; we want the avoidance of pain and the experience of pleasure, but we make the wrong move to achieve the desired result we want, and often end up disappointed because we get the exact opposite result from what we want. Neuroscientists have found that the parts of the brain that process financial losses are the same parts that respond to mortal threats.
Therefore, investors need simple systems, rules and procedures to protect us from ourselves. Success may be as much as 80% psychology and 20% mechanics. Here are some of the very real challenges investors face with the psychology of investing:
- Seeking confirmation of your beliefs, often called the “confirmation bias”. Investors tend to seek out and value information that confirms our own preconceptions and beliefs. This is very dangerous because it limits our ability to make objective, rational decisions.
- Valuing something we already own more that its true objective value. Also known as the “endowment effect”.
- Mistaking recent events for ongoing trends, otherwise known as the “recency bias”. This also is a very powerful and potentially damaging emotional response. This is the belief that recent events have more weight in our minds when it comes to something happening in the future. If stocks are going up, we tend to think they will continue to go up and if they are going down, they will continue to go down.
- Overconfidence by overestimating our abilities and our knowledge. This can be a recipe for disaster. A humorous example of this is that when polled, a clear majority of people (70-80%) say they are “above average” in almost every area……intelligence, ability, ability to drive, etc.
- Greed, gambling and the quest for the home run. It’s tempting to want to experience the great success of a super return, but it often comes as even great risk, and sometimes is literally too good to be true (financial scams).
- Negativity and loss aversion. Humans tend to recall negative experiences more vividly than they do positive ones. This is known as “negativity bias”. The truth is that the great investors of our time have viewed market declines as great buying opportunities. Warren Buffett, John Templeton, John Bogle, and on have all generated great wealth for themselves and their investors by staying disciplined and following the rules of their plan, “buy when others are selling and hold for the long term”. The trouble is that losing money causes investors so much pain that they tend to act irrationally just to avoid this possibility.
Our next communication will be about how to deal with these emotional challenges!
Paul Damon, CFP® ChFC® CLU® CAP® CEPA®