What makes a “good” investor? Perhaps it is someone who achieves consistent, strong returns over time. Whilst long-term wealth preservation and growth form part of the answer, two other key aspects are awareness and discipline. In particular, knowing that – as human beings – investors have weaknesses that can undermine their portfolios, and having a plan to deal with these.
#1 Anchoring
Humans have a tendency to refer to a significant past event or action when determining the value – or meaning – of current or future ones. For instance, imagine you have an argument with your spouse, during which he/she says something deeply hurtful to you. In the months and years ahead, you may interpret subsequent things they say and do in light of those past words.
A similar dynamic can occur with investing. We might look back on something in the past which we think is significant – such as a market crash – and let this largely dictate our investment choices and strategy now. However, it is important to recognise that the current or past price of an investment does not necessarily reflect its intrinsic value. Here, it helps to run a technical analysis to produce fair estimations and use these to help guide your strategy.
#2 Confirmation bias
It is uncomfortable to be told you are wrong. We all like to think we believe certain things for completely rational reasons, and that these are unassailable. This leads us to only find facts, information and other opinions which support our own – including those about investment choices we have made. However, this confirmation bias tendency can often lead us to ignore the alternatives, leading to costly mistakes later.
A good way to challenge this and refine investment strategy is to continually challenge it. This is actually a very rewarding process since you are more likely to feel confident in the investments you do eventually choose for your portfolio – since they have undergone more rigorous vetting.
#3 Neglecting probability
Have you ever played a card game like poker? If so, perhaps you experienced being dealt an exceptional hand – or even a terrible one. When this happens, in the following game rounds we tend to think we are more/less likely to be dealt the exact same hand again. Yet, statistically, the odds are no different to before. The same number of cards are still in the deck, and the dealer and players have no control over which cards come up.
Humans tend to misjudge probabilities with investing, too. For instance, just because a certain investment reached an all-time high a few months ago, does not mean it will do so again – eventually. Indeed, it might crash entirely. Here, it is crucial to remember that the past performance of an investment is not a guarantee of future results. Rather, the fundamentals of an investment – as well as other factors, like market sentiment – should be given more weight when constructing and balancing a portfolio.
#4 Groupthink
We all want to feel like we belong to something bigger than ourselves – a tribe, a movement or group of people. This stems from our prehistoric roots, when it was safer to band together for protection against threats in nature. However, this aspect to our psychology can be detrimental when it comes to investing. When we see lots of people investing in a particular investment, for instance, it can be difficult to resist the temptation to join – out of a fear of missing out (FOMO).
However, bear in mind that the majority is not always correct. Crowds can get swept up in “hype” emotions like fear and excitement, rather than acting out of reason and fair judgement. As a general rule, try not to make impulsive buy/sell decisions. It is better to wait days – even weeks – before acting, and to discuss this with your adviser, first.
#5 Loss aversion
Another well-documented aspect of human psychology is that we tend to prefer avoiding pain (or “loss”) more than we like to acquire rewards, or gains. This can lead investors to focus on mitigating losses more than concentrating on growth. For instance, it is often necessary to experience short term “pains” along your investment journey – e.g., months/years when the market falls – to achieve an overall trajectory of wealth growth.
Bear in mind that focusing on avoiding losses is likely to lead to repeated instances when you leave the market during bear (falling) markets and jump back in when they recover (crystallising several losses along the way).
Invitation
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This content is for information purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice regarding your affairs please consult your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.