8 Psychological Traps Investors Should Avoid
In 1994, in a southern state of the US, a woman named Diane Duyser woke up from her sleep like any other day. But little did she know that her life was going to change in a few moments. That morning, she went to the kitchen and put two slices of bread into the toaster for her breakfast. Just when she was about to take her first bite, she noticed something familiar. There was a face on the side of the bread. It was the face of the Virgin Mary.
Although it's strange that Mary decided to turn up on a piece of bread instead of at the Vatican or Times Square, this story is interesting for two reasons. One, she later sold the bread on eBay for $28,000. Second, there is nothing special about Diane Duyser. Seeing patterns is natural and, in stone age times, was also necessary for our survival.
Patterns helped us identify whether the shape in the bushes was a tiger or a deer. Now, after millions of years, even though we don't live in the Jungle anymore, the habit hasn't left us. We see shapes on the moon. We find dog-shaped clouds and elephant-shaped rocks. They are not a threat, but the problem comes when we apply the same principle to our investment decisions.
When we try to find strange patterns in candlestick charts, stock prices, company profits, and whatever data we get, and base that to predict the future.
This is not a good way of investing. The Stock Market is a complicated machine to make simple predictions like that. If you are someone who does that, then the next time you toast bread, look closely at the sides.
I have always been fascinated by human psychology. Our brain is a wonderful organ; it's like a supercomputer that can do amazing things, but it's not perfect. There are flaws, certain bugs that evolution left behind that influence how we think and act. In this blog, we will analyze eight strange games our minds play that make us bad investors. The last one on the list is the most common mistake most beginner investors make.
Most of the facts I explain in this blog come from the book "The Art of Thinking Clearly," written by Rolf Dobelli.
It's a great read, and you should definitely check it out. So, let's get started.
1. Gambler's Fallacy
Let's conduct an experiment. I am going to flip a coin. Okay, Heads. Okay, let's flip it again. Heads. Let's give it another try. Head Again. Now before I flip it again, I will give you a moment to predict the next result. What do you think it will be? You will choose tails if you think like the most, although heads are just as likely.
This is called the gambler's fallacy, and it makes us believe that things can't stay the same for long. A change has to happen at some point. But this need not be the case at all. A stock that has been going up can keep going up. And one that is making losses can keep making losses. There are many other complex factors at play here that can influence what happens to the price of a share. So be careful and don't invest like a gambler.
2. Contrast Effect
Another bias closely related to this is the contrast effect. Look at this image. The two gray square boxes in the center. Which is darker? Is it the left one or the right one? I'll give you a few seconds.
Both boxes are of the same color. But our perception is distorted because the differences are enhanced when we compare it to the outer box. Let's apply this to the stock market. Suppose the value of Tesla fell from $200 to $150 in a day. That's a 25% drop in price and a good time to grab a few shares at a low price right. But the thing to understand is that the price of a share is never 'low' or 'high.' It is what it is, and the only thing that matters is whether it goes up or down from that point. So always focus on the absolute price of a share or product rather than its relative price.
3. Overconfidence Effect
Let's go back to Tesla. What do you think of stock and the company? Climate change is real, and more nations are moving towards greener energy sources. So the demand for electric vehicles will naturally rise, and that's good news for Tesla.
And there is Musk, whose personality and charisma make us believe in the company. So most probably, it's a buy for most of us because, with the information we have, we are pretty confident that the stock has to do well in the future.
But then Tesla could fail. They had a head start in the electric space, but their cars are still expensive, and competition is picking up. And how the Tesla stock performs in the future will highly depend on a single person, Elon Musk, who sometimes acts impulsively. So if we decide to buy Tesla stocks based only on the rising demand for electric cars, we would be in for a surprise.
Sometimes we systematically overestimate our knowledge and use that to make predictions about the future. This is the overconfidence effect, where people think they know more than they actually do. I am guilty of this too. When Coinbase came with an IPO in 2021, I invested in it. I had done my research and was 100% sure that crypto would be going to the moon and that Coinbase would play an important part in it. And now, it's the most loss-making investment in my portfolio. I know it's very difficult to be cautious here. The only thing we can do is be critical of our knowledge and what we think we know.
4. Sunk cost fallacy
The day after I bought the coinbase stock, the price went on a decline. There were clear signs of the company going into trouble. If I had been careful, I could have seen the trend and sold it at $300, $200, or even $100.
But I didn't want to sell because I had already invested a good amount of money, and I didn't want that to go to waste. So, I held on to it. This is the sunk cost fallacy. There is famous quote.
“When you find yourself in a hole, the best thing you can do is stop digging.”
The price at which we buy should not influence our decision to sell. The decision should only be made considering the future prospects of the company. Unfortunately, sunk cost fallacy makes us hold onto our investments even when it's in our best interest to get rid of them.
5. Cognitive Dissonance
But then there was another reason I didn't sell the stock earlier. You might have heard the famous Aesop fable about the fox and the grapes. A fox tries to get grapes to eat but cannot reach them. He goes away in disgust, saying he never wanted them in the first place.
Sometimes we reinterpret things retrospectively to avoid admitting our mistakes. Even though it was clear to me that the stock was overvalued, I convinced myself that the decline was just temporary fluctuations in the market and that Coinbase would be back to its "correct price" soon. I was playing the fox, and this thinking is called Cognitive Dissonance.
6. Exponential Scale
Now let's do another experiment. Let's fold a paper in half and do that again and again 50 times. How thick do you think it will get? It will be 60 million miles after 50 folds. That's approximately the distance from Earth to the Sun.
Not what you expected, right. But If I had asked you how thick it would get if I stacked them one on top, then you can guess approximately. Why? The first was an exponential scale, and the second one was linear. We are bad when it comes to analyzing exponential or percentage growth. Again, our genetics are to blame.
Humans in the stone age times rarely came across situations of exponential scale. If one deer meant enough food for a week, two deer meant enough for two weeks. Life was simple. But now we are living in a different world. GDP is growing at 2% every year. Inflation is 5%. What does that even mean? A 5% inflation means the same money that gets you an apple today will only get you half an apple in 14 years. So when making decisions based on percentage growth, think carefully. A 1% difference in the return on investments may not look like much now but could mean another $100,000 in some years.
7. Alternative Paths
Like with exponential growth, we are also bad at assessing risk. Each and every decision we make leads us to several paths with various levels of risk. But we often only see the path with the least risk and ignore others. When Dogecoin was going halfway to the moon, Roy invested 2500 euros in it. His portfolio rose to 8000, then to 100,000, and then to 525,000 during the bull run. So sold his house and invested all his savings into the coin.
Then came the crash in May 2021, and his life crashed along with it. When things look good, people forget to consider the alternative paths our decisions can take. If we like something, we believe the risks are smaller and the benefits greater than they actually are. Our brain will do everything to convince us that our success is warranted. In short, risks are not always directly visible. So, think well about the worst-case scenario and what you have to lose before jumping into any investments. Now, to the most important mistake many new investors make.
8. Inaction
If you watched the last football World Cup final, in the penalty shootout you might have noticed that the goalkeeper moved to the right or left every time. According to a study by Israeli researcher Michael Bar-Eli, players normally shoot 1/3 of the time to the left, 1/3 to the right, and 1/3 to the center. However, goalkeepers still dive left or right. Why? It just looks better. This is called action bias.
Sometimes it is more impressive and less embarrassing to do the wrong thing and fail than to do nothing and watch. This normally happens to us when we start our investment journey. We do too much. We will buy a stock today and sell it tomorrow. We keep on checking the market every hour.
Ideally, it's better to dip our toes in slowly, watch and study the market behavior before making huge investments. But somehow, we can't stand inaction. Again our ancestors are to blame. If a shadow in the bush looks like a tiger, it's better to take some action to run and hide instead of taking a wait-and-see approach. But as Bagheera said, "The rules of the Jungle are not applicable in the stock market." So, if a situation is new or unclear, realize and assess your options before jumping into action.
“All of humanity’s problems stem from man’s inability to sit quietly in a room alone.”
As I mentioned earlier, we humans are not perfect, and it was never the goal of evolution to make us perfect. We evolved with only one goal in mind: survival. As long as we could advance beyond our competitors, certain aspects of our thinking remained, even though they are irrelevant in modern times.
This makes us puppets to our emotions, and we make decisions based on feelings rather than thoughts.
This is not restricted to our investments; the same flaws are in play when we budget, go shopping, or do anything that involves money. This blog is only a part of a series where I look at some strange ways we deal with money that are totally not in our best interest. So, do check out the other blogs as well. If we want to do better at our finances, we should always ask ourselves, "What do we think about this?" instead of "How do we feel about this?".
Disclaimer: The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. It is important to do your own analysis before making any investment.
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