Baseball, flirting and investing all have a large mental or psychological component. In the first two cases, everything is about confidence, but in investing, confidence can be a burden if it’s not justified.
You can choose your lottery numbers in any way you wish, but making and liquidating investments should be done based on facts and nothing else. Our minds evolved to deal with the threats and opportunities found on the Serengeti plain, not the NYSE, yet we still try to apply the same mental paradigms to things like investing. In addition, our subconscious fears and hopes influence our decisions to a greater degree than most of us realize. Mechanisms like these have an effect on every investor, but a few of the most common psychological pitfalls deserve a special mention.
“Until you can manage your mind, do not expect to manage money.” – Warren Buffet
Riding Your Losers and Cutting Your Winnings
One characteristic of a poor investor is that they can’t walk away from a badly performing stock even though it’s clear that the downward trend can only continue, yet they get jittery when a stock is performing well, and sell it long before it peaks.
It’s important to realize that your own actions and emotions affect share price movements. If a stock is performing well, it’s generally going to continue doing so at least for a while, and vice versa. If your strategy was “in at 27, out at 28.50” it’s fine to stick with that, assuming you have your reasons. Selling a stock you intended to hold for a longer period, or not selling one that’s falling though, should be seen as an exercise in math and reasoning, not finger-crossing.
Acting on Time Pressure
How many “special offers” on the internet have a countdown timer next to them? Some are calibrated in milliseconds as if this could influence any rational decision. Airline websites are programmed to slightly increase specific fares every time you visit, unless you delete their cookie. In both cases, the message is “buy now!”
Whether it’s the fear of losing or apprehension about missing out on a profit, this is one of the basic tricks every salesperson knows. Anxiety is the enemy of rational decisions. Even when a stock you own is apparently plummeting, it pays to look at the fundamental statistics once more. It might just be that a random blip was larger than normal, and then became amplified as nervous investors confused it with a genuine movement. Stocks are volatile, but the reasons to choose them shouldn’t be. Trying to time the market over short cycles is a game for mediums and tarot card readers.
To quote Warren Buffet again: “Be fearful when others are greedy, and be greedy when others are fearful!” We are all surrounded with information at every moment, from radio news to internet bulletins. The whole point of trading stocks is that every investor isn’t equally well informed, and recognizing the relative value of different sources of information is the key to investing successfully.
Bear in mind that what you read in the newspaper is only a condensed version of the deeper analysis. Stocks often move on the basis of perceptions or anticipation, but because enough people climb on the bandwagon, expectation becomes reality – but only for a while. Prices correct, given time, so learn enough to recognize what is and what isn’t important to a company’s success in the long run and invest according to this rather than what’s in the news this week.
Understand Where Your Money Is Going
Speculators buy stocks, investors buy into companies. If you’re not a technical analyst, there is absolutely no excuse for not researching a company you plan to invest in thoroughly. How it moves money around is one thing, but all major companies are based on offering products or services in some market, and this forms the basis of their success or failure. Many investors specialize in a single industry, the benefits of increased understanding hopefully balancing out the lack of diversification this entails.
It’s amazing how much our emotions and preconceptions affect how we see the world and the decisions we make. Data that doesn’t support what we already “know” or want to be true is soon forgotten, but a desperate investor will often see the slightest glimmer of hope as proof that his portfolio isn’t tanking.
Everybody can fall into one of the above traps and too much more to mention. In some cases, professionals such as CPAs and executives even fall for Ponzi schemes and similar scams, all of which have psychology at their core. Mental training, such as meditation or cognitive therapy, can help anyone gain greater control over their mind and therefore their decisions.