November 30, 2022
By
Joss Biggins

The 5 Psychological Pit Falls you have as an Investor

The 5 Psychological Pit Falls you have as an Investor

As investors, because we are human, we must deal with our two greatest obstacles: cognitive biases & emotional biases.

Cognitive biases are information processing or memory errors that are common to all humans. Emotional biases are about our feelings, perceptions or beliefs.

Investing is an incredibly challenging game to play. Picking the right stock, investing the right amount, and picking the right time to buy or sell are not the hard parts (although those are all extremely challenging).

The hard part is dealing with your own mind & your own psychology.

Here are five of the most common psychological pitfalls I see when working with investors.

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1. Framing  🖼

Framing is the tendency for people to respond to various situations differently, based on the context in which the information was presented.

  • Example: we will share/think about our gains in dollar terms ($), but share/think about our losses in percentage(%) terms. The internal narrative of: ‘I lost $10,000’ sounds a lot worse than the narrative of: ‘I am down 10%.' 10% is just a number. Ten thousand dollars on the other hand is real, it’s tangible, you could have went on an incredible vacation with that money. Now? You are stuck at home. Sucks to suck.

2. Self-Attribution 🥰

You think that your success is due to the actions you have taken. Failure on the other hand, is due to outside circumstances. Depending on the outcome, you drastically underweight or overweigh the effect the external world had on the outcome on your decision. Maybe you find yourself hearing some of the following self-talk (highly common amongst young men, like myself):

  • Example: ‘My stock picks won, but my advisors? They tanked!’ Or, ‘my friend convinced me to buy/sell, when I really should have sold/bought!’ Or, ‘how was I supposed to know we were heading into a recession!’

3. Loss Aversion & Regret Aversion 😥

Loss Aversion is the tendency to feel a stronger impulse to avoid losses than to acquire gains. This can be thought about in terms of that one negative comment you see on social media, versus the 30 positive ones. This is a primal wiring that makes us fear things that hurt us. It keeps us alive in the jungle, it really doesn’t help us that much in buying stocks.

  • Example: You’d rather just put money away in a high interest savings account or buy some GICs rather than invest in the stock market. The fear of losing stops you from playing the game.

Regret Aversion is what you do when you avoid making decisions because you fear whatever you decide to do will result in a horrible outcome. Loss Aversion & Regret Aversion are ultimately confidence issues.

  • Example: Remember that time you held those losing positions waayyy too long in order to avoid admitting errors and realizing losses? Regret aversion keeps us thinking that penny stock is going to come back, it has too! Right? There is no way I was wrong. I won’t have to feel that feeling if I don’t make it real. ‘realizing’ gains or losses, (spoiler alert) makes them real in the world and real in your mind. This leads to more irrational investing.

4. Mental Accounting 🧠

Mental Accounting causes investors to irrationally treat various sums of money differently based on where & how these sums are mentally categorized. Money is actually just money, regardless of where it came from. All $20 bills look the same. Rational investors know this.

  • Example: ‘Paying with the house money’. The decision you are making is deeply effected by the fact that you are already ‘up big’ on the stock you’ve selected. This causes you to take more risk than you would if you had just bought in at the current price. This leads to poor asset allocation decisions and risk management practices.

5. Representativeness 👉 👈

Representativeness is the mental tendency to illogically link meaning or similarity to two things that are in fact unrelated. This shows up when investors say to themselves: ‘oh, this thing is like that thing (so I can use the mental model I used before with that thing on this thing) when this thing is really not like that thing at all. But it is easier for an investor to be lazy with their mental models, and use confirmation biases to assume they are correct.

  • Example: IPOs. Investors often think they are always good opportunities, when they are generally not. All IPOs are in fact VERY different and have a unique set of aspects and circumstances associated. Just because both of those people have red shoes doesn’t mean they are very similar at all.

BONUS! 🤫

  • Endowment is when an investor places more value on the asset they hold rather than the asset they don’t hold. It’s worth more in your eyes because you own it. (pssst* - It’s not)
  • Example: You may think your Toyota is worth more because it’s yours, and as a result you’re frustrated with the market, because it doesn’t place the correct price on it. Conversely, if somebody else owns a Toyota, you don’t value it like you would if it was yours.

Okay, but, what do I do about these horrible mind games I’m playing on myself?

Your task is to become a rational investor. Becoming a rational investor is furthered by the awareness of these mind games which you are playing on yourself. You cannot eradicate your mental predispositions. Self awareness is the key and meditation helps drastically with this. My greatest advice on how to become a better investor? Meditate daily. Learn to observe yourself and the world around you.

Investing in theory is a simple concept. Our relationship with that concept is deeply complex and based so much on the context of our own lives. This is what makes investing interesting and why we are seeing so much of an increase in popularity of investing in popular culture. Which I believe is largely a mistake. But I will save that for our next blog.

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