by Tyler Curtis
Investors who adopt a disciplined strategy and manage their emotions make better decisions over the long run. Taking control of your emotions in relation to investing seems like an easy task, but in practice it proves to be quite difficult if not impossible to achieve in perfection. I recently came across Kiplinger’s investor psychology quiz which addresses the ways our minds often sabotage financial decisions. As I have mentioned before the first step to mastering your emotions is awareness. This quiz is a great reminder of the subconscious tricks the brain likes to play on us in order to alter our perception of a situation.
Here are some topics from the quiz that I find the most intriguing.
As markets rise investors begin to pile in one after another. Correspondingly portfolio values climb and investors begin to think primitively toward their investment decisions because the market has become an “easy” place to make money. The more money that is made and higher the market goes, it only gets harder to think logically.
One of the first things we all learn while growing up is that something is not safe just because everyone else is doing it, though it seems we quickly forget this mentality when it comes to investing. The smart investor will tread cautiously as the market is making new highs and everyone is piling in, as these are the times when you must stick with your investment plan and not chase after higher riskier returns.
Behavioral experts agree that it is regret not excitement or envy that ultimately drives people into rising markets when they see others making money. It can be hard to stand by and watch others who have made a killing on the most recent investment trend, and the regret of not enjoying the ride up can cause you to jump in at just the wrong time.
The recency effect is a cognitive bias where we assign too much merit to an observation that occurred recently in comparison to earlier observations or the trend represented by the entire record of observations. For example following a recession it seems as though the stock market only keeps getting lower. Headlines are cluttered with bad financial news and corruption. We forget that in the long term, the stock market has been the best way to grow your money. The result of this brand of thinking is to abandon the stock market and miss out on the gains when the economy recovers.
Sometimes we will ourselves to believe certain things. Confirmation bias is our tendency to favor information that confirms our preconceptions or hypotheses regardless of whether the information is true. As a result, we gather evidence and recall information from memory selectively causing us to interpret it in a biased way. For example, an investor may get a call from a broker pushing his most recent penny stock pick and be intrigued by the return potential. That investor may then choose to research the stock in order to prove that the hyped potential is valid. During the process the investor may find many green flags about the stock while glossing over any devastating financial red flags.
These are just a few of the cognitive hurdles investors face when making decisions. It’s important to adopt an investment strategy that both recognizes these emotional factors and doesn’t allow you to give in to them.