Are you overly anxious and panicked when the markets are volatile? Or overly optimistic that everything will turn out fine?
Both reactions are natural parts of your psychological makeup, but did you know they can impede progress towards your investment goals?
Unless you have been living in a 1:1 brick room for the last year, you are aware that marijuana stocks have dominated the Canadian investment scene of late. Aurora Cannabis and Canopy Growth are two companies that have been leading the charge.
A friend of mine, who was fortunate enough to buy shares of Aurora at $2, recently asked if it was a good time to cash out his earnings. This was when Aurora was trading at is all-time high of $15.
The conversation that immediately followed perfectly illustrated some of the psychological pitfalls people commit when it comes to investing their own money:
“Should I sell?”
“You’re up 700% on your initial investment, what more do you want?”
“But what if it keeps going up?”
“Then don’t sell it!”
“Yea, but then what if it goes down!?”
Every investor has or will have this conversation at least once in their lifetime. The bad news? None of us hold any control over the financial markets. Warren Buffet himself can’t predict with certainty if a stock will go up, down, or sideways. The good news? You can at least exert some control over your psychological responses.
These are the seven psychological pitfalls of investing – and how you can avoid them.
“My brother-in-law said his best friend’s cousin heard from his neighbour that this penny stock will go to the moon, there is no way I can lose!”
People tend to overestimate the likelihood of positive results on everything from the weather to investing. This psychological bias explains why people are so often disappointed by their investment performance – they simply felt they would do better.
If you base your financial goals on unrealistic investment returns, you will almost certainly overshoot your expected retirement date, projected retirement income, or estate planning forecasts.
So how can you avoid this feeling of disappointment? By consciously compensating for your natural optimism. Some people are calibrated better than others, but studies indicate that if you feel there is a 99% chance of something happening, the actual odds are closer to 85%.
“Its trading at the all-time low, it’s impossible for it to go anywhere else but up!”
Another powerful psychological bias is overconfidence. Just as people tend to be overly optimistic about the probability for positive results, they also tend to be overconfident about their own talents. Many investors think that they can “outsmart the market” – and control unpredictable events such as stock market volatility.
This leads to the most common pitfalls of investing – market timing. Confident in their own abilities, many investors try to time the market so that they always buy at the lowest low and sell at the highest high – despite the fact that not even the world’s most accomplished hedge fund managers can do this consistently.
Recognizing overconfidence is the first step towards dealing with it. Be honest about your abilities, and if you find yourself falling into traps such as market timing, take a step back and rethink your approach.
“I was going to buy Aurora at $0.40 but didn’t. Now it’s trading at $12. I knew this would happen! I knew I should have bought it!”
If I had a penny for every time I heard that, I’d have twenty dollars in my pocket. Hindsight is the tendency to be knowledgeable about an event only after the fact. It’s pretending you knew something would happen all along– even though you didn’t. Hindsight can lead you to believe that events are far more predictable than they really are, raising unrealistic expectations about how well your investments will perform.
If you find yourself confidently declaring that you “knew it all along”, ask yourself whether you really did. As with optimism and over confidence, you may have to consciously compensate for hindsight.
“I need to click the refresh button just one…more…time”
Do you follow the performance of your investments minute-by-minute on BNN or the Internet? Do you dwell on short-term changes in the market value of your investments? Do you fixate on the negative performance of a single investment, even when your overall portfolio is doing well? These can all be signs of obsessive behavior commonly displayed by investors.
Take a step back and look at the big picture. Are you on track to achieving your longer-term goals? Are you comfortable with the level of investment risk in your portfolio? If not, you may have to make adjustments to stop obsessing about short-term events.
“Blackberry is going to bounce back. It has to!”
When stock markets go down, investors can sometimes panic and sell what is still fundamentally a good investment. The flipside of this is denial – when investors continue to hold an investment that has gone bad, thinking it will eventually come back.
It can be hard, but when an investment has fundamentally deteriorated, it may be time to sell. Having an investment discipline in place with specific, rational criteria for buying and selling can help you overcome this tendency.
“I just need Tron to go from $0.02 to $1.00 and I’m rich!”
The desire to “get rich quick” compels many investors to take bigger risks than they should, such as investing too much in a single investment. When the risk doesn’t pay off, it can jeopardize their financial security. That doesn’t mean you should never take on risk – it’s a healthy part of investing.
The key is to take well-calculated risks within a properly diversified investment portfolio, which is designed with your personal risk tolerance in mind. That way, when the occasional big play doesn’t pay off, the impact is mitigated by the other investments in your portfolio.
- Herd instinct
“Debra from Accounting just bought pot stocks, I need to buy some too! FOMO!”
When we see other people doing something, we tend to think it must be a good thing and should therefore do it too. This “herd instinct” is often behind many of the sharp ups and downs in the financial markets. When other people are buying and propelling the market upwards, we buy too, which in turn sends the market soaring even higher. Similarly, when other people sell in a panic and send the market spiraling downwards, we sell too, fueling the decline.
Unfortunately, this often results in buying at the height of the market euphoria and selling close to the depths of the panic. Instead of following the herd, follow a disciplined investment strategy based on logic and reason. Stop trying to chase the markets! You will lose every time.
Successful investing over the long term is less about how the markets are doing than how we react to what the markets are doing. Unfortunately, many of our natural psychological reactions – like denial, panic or greed – can impede our long-term success.
Taking a disciplined approach that removes the emotions and guesswork from investing can help you avoid these psychological pitfalls.
This is a guest post by Ramsey Melhem, an Investment Advisor with RBC Dominion Securities