Investor psychology: watch out for biases!
As investors, we all try to make rational decisions. Many cognitive biases prevent us from doing so and frequently cause us to make bad decisions. The science that studies these biases is called behavioral finance. It is important to understand them first To invest in the stock market. A review of the best known ones, and how to counteract them.
Confirmation bias
We start with a great classic in investor psychology: it consists in processing only the information that suits us.
If I am enthusiastic about investing in Tesla, I will tend to look only at the good aspects: the attractive curve, the positive sales figures, a promising future,... forgetting or ignoring to look at the risks: a huge valuation in relation to income, growing competition, growing competition, problems with the quality of finishes, a visionary and charismatic but solitary leader, representing a big SPOF (Single Point Of Failure),...
How to avoid it: you have to remain pragmatic and not get carried away by your emotions. The simplest thing is to have an analysis model that helps in decision-making. If your assumptions are reasonable, the model won't lie to you.
The group effect
It is tempting to be convinced by the opinion shared by a large number of people, even if they are absolutely not competent on the subject. The ensuing mass movements can create over-reactions from the market, both up and down. Just look at the quantity of Robinhood customers (US trading app) who have purchased shares Hertz, mostly first-time investors sharing their belief in “buy the dip” on Twitter. As Hertz is a bankrupt company, the rest was less joyful for our neophyte investors. This phenomenon is the enemy of a good wealth management.
How to avoid it: always ask yourself if your decision is taken on a fresh mind after a rigorous analysis of the investment, or if you feel overwhelmed by FOMO (Fear Of Missing Out) due to the sudden enthusiasm of many people, often on social networks. You can also invest in ETF to no longer take positions on specific actions.
Over-reaction and under-reaction
A disproportionate reaction to an event occurs when the investor reacts to news in a way that is more significant than its real impact. When the market is bullish, the investor can remain optimistic for a long time and continue to invest. Conversely, when it is bearish, pessimism can last longer than necessary. When a majority of investors are biased in this way, we can witness a sudden surge or fall in the market that is completely uncorrelated to reality. These movements are particularly violent in crypto challenge or on the Bitcoin.
How to avoid it : do not fall into the trap of wet finger analysis of an event that occurs “Hey this company announces that it has found a vaccine for COVID, I don't know much about the health process of validating a vaccine but it is certainly a great value to buy!”. If you don't have experience with a subject, don't invest.
Selective memory
We all have a more or less selective memory. When you invest, too selective memory can be very expensive. Indeed, we may tend to retain only our best investments and forget our mistakes, for reasons of ego or social recognition. This behavior prevents you from learning from your mistakes and can cause you to repeat them over and over again.
How to avoid it: developing humility and having a rigorous follow-up process is key. With each transaction, write down the details in a file (or soon Finary) and add a comment explaining why you are buying or selling and what you could do better next time.
The trap of unrecoverable losses and the bettor's error
Having the humility to accept mistakes or failure is an indispensable quality.
Not daring to take a loss is very dangerous because it can lead to a situation of denial. Not selling a stock when you are a big loser and extending the deadline will only amplify the losses. This can be made worse by the bettor's error, where the investor will think that if an event occurs many times in a row (in this case a drop in their investment), the opposite event will end up happening enough to compensate. It is wiser to accept having made a mistake or simply not having had the facts in your favor, to cut your loss and to move on.
How to avoid it : When you buy, set a goal and a limit-stop, a low loss limit at which you sell. If this limit stop is reached, cash in the losses and do your post-mortem analysis.
The trap of irrational exuberance
To be placed at the next dinner party in town: irrational exuberance is simply a reminder that history cannot be used to predict the future with certainty. Speculators use chart analysis and historical trends to try to predict future movements. But in the economy at the scale of our lives, history does not repeat itself. The world is changing. Economic events occur in a very specific context. Who could have predicted that the COVID crisis would generate a bull market of several months in the short term, stimulated by central banks?
Irrational exuberance occurs when enough over-confident investors invest at the same time, causing an artificial rise in the market that will inevitably end in a correction. They all lead to bubbles: tulips (17th century), Great Depression (1929), internet/dotcom (2000), American real estate (2008). When is the next one?
How to avoid it : Avoid analysts announcing market movements with charts, history, and projections to back them up. They may be right from time to time but like in the casino, it never lasts. Invest only based on your knowledge of the current economy and your beliefs for its future evolution.
In short
Having these main pitfalls in mind allows you to be more pragmatic in the face of your emotions and biases. To invest rigorously, a checklist can be a good solution, listing the critical elements to check before each position is taken. This will ensure that you have invested wisely in an asset that matches your goals and values.
