Over two thousand years ago, Aristotle defined man as “a rational animal.” But every day, we can see evidence that humans aren’t always as rational as we think we are. We might be able to reason, but we also make decisions based on emotion, gut feelings, or bad advice. That can be disastrous when investing. Understanding your own psychology can help you invest more rationally.
Why You’re Not as Rational as You Think
We all know that other people are prone to making bad decisions. We can watch a relative fall prey to a conspiracy or a friend get into an MLM scam, and it makes us aware that even smart people can make mistakes. But too often, we exempt ourselves from this realization.
The best step to become a better decision-maker is recognizing you’re imperfect at it. Often, your first impulses are wrong. Everyone’s are. What will make you better at being more rational is the knowledge that you need to check these first impulses against good evidence.
Emotions can often be an enemy when investing. If you’re in a good mood, you may feel so optimistic you back high-risk products that aren’t good deals. But if you’re feeling fearful or recently lost money, you’ll naturally shy away from even the risks you should be taking.
At an extreme, investors can adopt a gambling mentality. They invest, not to gradually grow their wealth, but for the quick dopamine rush of a big win. That can lead them to over-manage their portfolio with too many trades, chase high-reward possibilities without considering risk, and worse.
Behavioral Finance
The field of behavioral finance, or the psychology of investing and financial decisions, was invented by Daniel Kahneman and Amos Tversky. In their book, Thinking Fast and Slow, they explained the human brain has two systems for making decisions. System 1 is our intuition, our mind’s quick way of solving problems and guessing the solution. System 2 is our ability to slow down and work through a problem methodically.
System 1 is useful for working out, quicker than words, that there might be a tiger in those bushes, or that a car is about to merge into your lane. It might give you a gut feeling that an investment is a good one. But System 1 is prone to cognitive biases, shortcuts your brain takes to come up with a conclusion quickly. Thus, that intuition isn’t as useful as bringing in System 2, which can actually work out the reasons for and against that investment.
Common Cognitive Biases
Humans tend to fall into the same mistakes, since our brains are running the same software. Here are a few common ones that can hurt your investments.
Overconfidence
This is the common tendency to overrate our own ability. It often comes from another bias, the Hindsight Bias. This is when we look at decisions we made in the past. Say you bought a stock that turned out to skyrocket later. That might make you believe you’re an investing genius. In reality, you didn’t know it was going to skyrocket, and other stocks you picked didn’t. You probably got lucky.
Avoid this fallacy by researching more than you think you need to, and listening to the advice of those with more experience.
Sunk Cost Fallacy
When we’ve spent money or time on something, we tend to believe it was a good decision. We don’t like the feeling that we’ve made a mistake. That often leads people to stick to bad investments long after the warning signs are visible, because we’re still hoping they’ll turn upward again.
Of course, sometimes holding onto stock during a temporary decline is the smartest choice! Just make sure it’s because you have a reasonable hope of improvement, not because you’re afraid of writing off the loss.
Recency Bias
This is the tendency to look only at the most recent evidence. So a stock that’s only gone up in the past few years looks like a sure thing, while something that’s recently been low looks like a disaster.
When you take a longer view, you’ll see that every “up” does eventually come down. “Sure things” don’t exist in investing.
Peer Pressure
Maybe all your tech colleagues are trading crypto. Maybe you hang out with people older than you, with a lower risk tolerance. Psychology predicts that you’ll want to invest the way they do. But what your friends are doing tells you nothing about what you should do. You’re an individual, with a financial situation that’s unique. And, of course, there’s no proof your friends are any good at investing. If you need help, look for professional advice, don’t just mimic your friends—even if they’re making money with their strategy.
How to Avoid Psychological Pitfalls When Investing
Luckily, despite our many psychological barriers to good investing, it’s possible to invest rationally. We can train ourselves over time to follow good investment practices. That means taking time to consider rationally, using our brains’ System 2, the pros and cons of every decision. By being aware of cognitive biases, we can steer clear of each.
The first solid rule of rational investing is to have a trading plan. Instead of making each investment decision in a vacuum, have a plan you use to assess all possible investments. This can include balancing your portfolio between low and high risk investments and having benchmarks for when to buy and sell. You should always exercise discipline when it comes to following that plan. If your plan says to buy and hold, don’t give in to the temptation to constantly check on the investment.
The second rule is to listen to good investment advice. A good advisor is hard to find and worth their weight in gold. Because their money isn’t on the line, they’re much less likely to fall prey to emotional decisions. And, as professionals, they already know how to make and stick to a trading plan. Have your advisor help you create one of your own.
Beat Your Own Psychology By Getting Sound Investing Advice
Getting a second point of view is a solid way of avoiding bias and emotional errors. It’s why you often want a second opinion on your health, and why big hiring decisions are made by committee. One person can often spot the flaws in someone else’s reasoning better than their own. For that reason, a financial advisor is absolutely essential for anyone trying to invest seriously. You can find an excellent, thoroughly-vetted advisor by contacting us today.
