5 psychological traps and biases to avoid when investing your money
When you’re investing your money in the market, there are several psychological traps you may fall into that could influence your decisions and ultimately hinder the performance of your portfolio.
Thankfully, when you’re aware of these behavioural biases, you can take steps to avoid acting on them.
So, read on to discover five of the most prevalent psychological traps and biases you might be prone to, and how to avoid them affecting you and your wealth.
1. Confirmation bias
Perhaps one of the more common psychological traps, confirmation bias occurs when you make decisions based on pre-established assumptions rather than factual evidence.
A useful way to understand confirmation bias is with newspapers. Individuals are often more likely to read a paper that aligns with their political stance, and they may seek out information – perhaps even subconsciously – that confirms their preconceived beliefs.
Even though confirmation bias can sometimes be harmless, you could potentially lose a significant sum of money if it distorts your investment strategy. For instance, if you have a pre-established belief that a particular sector or industry will perform well, you may gravitate towards information that confirms this.
Conversely, you may ignore evidence that an investment won’t perform as well as you think, leading you to invest in or hold onto it, despite information suggesting the opposite.
To avoid this bias, you may want to closely examine your investment beliefs and search for ways you may be wrong, rather than the ways you’re right. When you’ve considered both sides, you can weigh the facts to make an informed decision.
It may also be worth seeking contrary advice that challenges your point of view, perhaps from a financial planner.
2. Recency bias
Also known as “availability bias”, this psychological trap is the tendency to make important decisions based on recent events, particularly negative ones. Meanwhile, you may consider less recent events irrelevant or forget they happened altogether.
For example, imagine you asked an investor whether they thought the market uncertainty during the 2008 financial crash or the Covid-19 pandemic was worse. They may well say the latter, even if the former negatively affected their portfolio more, simply because they remember it more clearly.
If you always believe that circumstances are worse now than in the past, you could create a negative outlook that makes you more likely to avoid risk.
To prevent this bias from affecting your investment growth, it may be prudent to limit your exposure to financial news. Media outlets typically design headlines to capture your attention, and that often means focusing on the negatives. While it’s good to stay up to date, it may not be necessary to check industry news daily as it could do nothing but fuel your concerns.
One of the helpful things about working with a financial planner is that they usually understand events in the wider market and can help you build a balanced portfolio accordingly.
3. Herd mentality
Herd mentality, or “trend chasing”, is when you follow the decisions of the crowd.
Perhaps one of the more memorable examples of herd mentality is the dot-com bubble in the late 1990s. As the internet became popularised, many investors flocked to stocks with “dot-com” names, believing that they were getting in on the ground floor of a future giant.
Instead, many of these companies collapsed in their infancy despite their promise, and investors lost a considerable sum of money as a result.
If you follow the crowd when you invest, you could end up making rash decisions that don’t align with your personal goals, tolerance for risk, or wider investment strategy. It’s worth remembering that just because a company has performed well in the past, doesn’t mean it will again.
You may want to stop looking at the actions of others and study the facts yourself. If you find that many are investing in a particular company, it may be prudent to ask yourself why people are doing this, rather than jumping on the bandwagon.
4. Outcome bias
Outcome bias, or “hindsight bias”, is the perception that past events were entirely predictable when looking back, despite this not being the case. You might find yourself thinking that you knew a certain stock would rise or fall in value and wish you had invested accordingly, even though this belief is almost exclusively informed by what actually happened.
This could be risky behaviour when you invest, as it could prevent you from objectively assessing and learning from your past decisions.
In reality, it’s difficult for even the most informed investor to predict market events exactly as they occur.
To prevent outcome bias from affecting the performance of your investments, it may be wise to keep a journal detailing your past decisions that you can refer to at a later date, so you can accurately reflect on previous events.
5. Loss aversion
Loss aversion is a psychological phenomenon that suggests individuals tend to feel the pain of loss twice as strongly as the pleasure of an equivalent gain. As a result, it can lead you to make decisions that avoid losses as far as possible, potentially forgoing the opportunity for gains.
Imagine you’re offered a guaranteed payment of £900 or a 90% chance of winning £1,000 (alongside a 10% chance of winning nothing). You may feel inclined to avoid any risk at all and take the £900, even though the odds of winning the larger sum are in your favour.
However, if you’re presented with a choice between losing £900 or taking a 90% chance to lose £1,000 (with a 10% chance of losing nothing), you may prefer the second option, taking a riskier decision in hopes of avoiding a loss.
This could lead to an inconsistent investing strategy, as you may subconsciously avoid the stress of loss, even if it means passing up on the opportunity for gains. As a result, you may become too risk-averse for your own good and fail to achieve the growth you potentially might be able to.
To prevent this, you may want to avoid getting too emotionally involved with your investments and remember that many risks you may face are often beyond your control.
Above all, a financial planner could help you assess your long-term appetite for risk and design a portfolio for you accordingly.
Get in touch
If you’d like help managing your wealth while safely avoiding these psychological traps and biases, please do get in touch with us at Britannic Place.
Email firstname.lastname@example.org or call 01905 419890 to speak to us today.
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.