Market Psychology: 9 Psychological Traps To Avoid When Investing In A Volatile Market
A lot has been written about the dangers of certain behavioral and psychological traps, which are often utilized to lure people into making a bad investment decision that ends up affecting their entire lives. Often, the most archetypal forms of dysfunctional market psychology tend to manifest in investor behavior.
It is no secret that humans have historically been known to make bad decisions, and we often fail to learn from our past mistakes as well. In fact, when you examine the psychology of investing, you’ll find that this common human flaw is quite prevalent in Wall Street, and manifests itself as being overconfident, overly compulsive, overly timid and too grave.
Market Psychology: The Fear of Missing Out
The fear of missing out aka FOMO, is such a powerful phenomenon of modern culture that the phrase has even made it to the Oxford English Dictionary. Just looking through social media sites like Facebook and Instagram can spark surges of jealousy as you scroll through a seemingly endless trope of others’ picture-perfect existences, which are often characterized by things like eating out at expensive restaurants or traveling to exotic destinations. The fear of missing out is essentially a deep-seated fear that someone else’s life is infinitely better than yours, thus making your existence inadequate.
While the fear of missing out has always more or less been a part of human life, it has become more pervasive in recent years due to the advent of social media. It has become a daily habit of ours to check our social media profiles every minute or every hour, just so we can catch up on what our favorite content creators have put out. And while we may not necessarily have a particular interest in something like dog racing, for example, we may still feel compelled to follow the latest dog racing event for fear of missing out on what could possibly be a momentous event in the world of this obscure sport.
Fear Of Missing Out Psychology
By definition, the fear of missing out is counter-productive because it arouses feelings of inadequacy, jealousy, unhappiness, and disappointment with our own lives, and it can lead to a spiral of bad-decision making. These are some of the most common fomo symptoms described in market psychology books. But, the fear of missing out is especially toxic when it comes to investment strategy. For example, hearing your neighbor drone on about how awesomely their stock has performed in the past quarter due to their investment strategy can leave you feeling incredibly dissatisfied with your own investment methods, and thus lead you to make rash and compulsive changes to your investment tactics, like taking on more risk even though the market is at an all-time high.
Fear Of Missing Out Social Media
What social media has done is to simply extend the influence of the fear of missing out on to investment strategies in what has been termed “fear of missing out stock market”. Thanks to the internet, investors are constantly receiving a stream of information on the amazing performance of the Dow Jones Industrial Average, the S&P 500 as well as the NASDAQ, leading many to question why their own diversified portfolio is seemingly exhibiting below-par performance.
Want to know how to deal with fomo? After all, how can you be happy with a seemingly underperforming diversified strategy when you’re constantly being shown that a non-diversified approach has bigger returns? The answer is, you can’t, and most people are bound to question and even change their investment strategies based on information that they encounter on the internet and social media.
Fear Of Missing Out Research
What causes fomo? Investor fear of missing out is particularly influenced by a preoccupation with “recency”. That is, the fear of missing out tends to go up a notch when the market experiences an upward streak. However, once you take your head out of the social media created hype over what’s going on in the market, you’ll realize that having a diversified portfolio offers the best tradeoff between capitalizing on returns while minimizing your risk.
That said, it’s hard to remember all that when we see our neighbors and colleagues benefitting off the latest market trends while we sit in the corner with the steady progress of our diversified portfolio, which causes us to “miss out” on all the action.
We fail to realize that changing one’s portfolio in order to benefit from a play that has already happened and passed would simply be misguided and senseless. First of all, you’d have to sell off assets with flat prices that may be undervalued due to current market conditions, only to purchase ridiculously expensive assets whose prices have increased to due recent growth. Alas, this is what the fear of missing out can do to you if you’re not careful, and you want to avoid this type of decision-making at all costs in order to protect your diversified investment. This is how to ignore fomo.
Common Market Psychology Traps to Avoid
Here are just a few of the most prevalent psychological traps that you can come across as an investor, and how to evade them.
The anchoring trap means that you place too much importance on one’s initial thoughts on a particular investment, especially relating to forex market psychology. For instance, let’s say you were to bet on a boxing match and decide to pick a fighter based on the number of punches they’ve made over the past several fights they’ve had. Now, you might come out all right if you choose the more statistically active fighter, but that doesn’t’ mean that you should discount the fighter with the least punches because it could mean that they’ve won their last several fights through first-round knockouts. So, make sure you have all the facts and don’t take any metric at face value, as it could yield different results when taken from a different context.
Another example; let’s say that there’s a company that seems successful and has had a great track record the past. Such a company will inspire a lot of investor confidence, but you may later find that preconceptions on this company are completely incorrect when considering its current or future situation.
A good example of such a scenario is Radio Shack, a company that was once the leading provider or personal gadgets and electronics during the 1980s and 1990s but was later obliterated by the emergence of the online retail sector with giants like Amazon (AMZN). People who invested in Radio Shack based on past perceptions of the company ended up losing big time when the company eventually filed for bankruptcy, not just once, but multiple times. The company went from having 7, 300 outlets at its prime to now having just 70 stores by the end of 2017.
The best way to avoid falling into the same trap is to be open-minded when it comes to the sources of information that you consult for investment advice and be flexible enough to accept that even the most seemingly untouchable companies can be obliterated. Managers too can vanish in times of economic difficulty.
Sunk Cost Trap
The equally dangerous sunk cost trap refers to only protecting your investment choices psychologically instead of doing so in reality, which can be very dangerous for your investment. Taking the “L”, as it’s commonly called, is one of the hardest things to do, especially when you know that you lost due to your own choices or the choices made by someone who was given the power to do so by you. That said, it’s no use staying in an investment if it is already tanking either.
For example, one would have to wait at least a decade before you even break even on stocks that were purchased at the in 1999 when the dot.com explosion was at its highest. Your best bet, in this case, is to cut your losses and rather invest in asset classes that have a more promising future, as maintaining an emotional attachment to bad investments can only lead to further losses.
The confirmation trap is characterized by the act of continuing to seek out the counsel of the same people who gave you bad advice and are still making the same mistakes as before. Instead, try and seek out new sources of information and get a fresh perspective that is based on fact and integrity.
For example, if you’re holding on to stock that is tanking at a rate of 30% just because there’s someone else in the same boat as you who’s hanging on, then you’re both just deluding each other and yourselves, and this type of behavior will most likely not work out for either of you in the long run.
The blindness trap refers to the act of actively shutting out other sources of information on the prevailing market conditions just so you can continue to avoid facing the inevitable losses that you’ll experience.
Most people can often feel it in their gut when there’s an issue with their investment, whether its market warnings or a major scandal within the company, and yet they’ll actively avoid the financial headlines in order to keep their blinders on.
Then there’s the relativity trap. First, you need to acknowledge that different people come from different backgrounds with different circumstances when it comes to their career prospects, family, work and potential inheritances. So, even though you might want to be conscious of the words and actions of others, it’s important to understand that their viewpoints and the overall situation are not all that relevant when taken outside their own individual context.
So, the first person whose context you must take into consideration when investing is yours. You may have acquaintances with more money and with more of a proclivity for risk than you do, but if you have a modest income and are risk-averse then stick to your own lane.
Irrational Exuberance Trap
Believing that the past glory of a certain company’s performance is an indication of its future prospects is tantamount to thinking that the market does not have any variations. Truth is, change is the only constant in the market and uncertainty will always be present.
The market will always experience ups and downs, industry-wide losses, mini-bubbles, big bubbles, overheated stocks and panic selling in emerging regions as well as other unforeseen events that affect the investment. You’re simply being arrogant if you think that past market conditions are going to remain the same based on past performance. In fact, overconfident investors tend to pump up the market so much that it ends up experiencing huge corrections as a result. Of course, the ones who lose the most when this happens are investors that choose to believe that the bull market run will always be there.
The pseudo-certainty trap is based on investors’ sensitivities to risk. For example, if an investor thinks that they’ll have a positive return, they’re most likely to limit their risk of exposure in order to protect the lead. However, if investors think that they’re going to experience losses in the near future, they’re most likely seek more risk.
So, an investor with a portfolio that’s performing well is most likely to avoid risk than an investor with a portfolio that’s heading for catastrophe. That’s because they’re of the mindset that they’ll just win it all back, and while they may not be willing to create capital, most investors are prepared to risk capital just to “reclaim” it again. However, how long do you think you’ll last if you only apply the brakes of your car when you’re in the lead?
The superiority trap is really dangerous and often happens when investors become know-it-alls that think they know better than the market and even expert analysts. Just because you’re well educated and somewhat clever doesn’t mean that you can’t use independent advice, especially if it’s good. You also have to keep in mind that the market is made up of a complex system of different moving parts that you won’t always outwit. That said, a lot of investors have tried doing just that in the past, and have lost inordinate amounts of money as a result, and people with this mindset can easily fall victim to the psychological traps when investing.
In fact, there have been instances of brilliant professors with Ph.D.’s that have fallen prey to the mentality of overconfidence, and through over calculation, ended up making the wrong decisions. While most Ph.D.’s are actually good at what they do, it is often the guy with the high school degree or undergrad college level education that really cuts it in the market, similar to the Bobby Axelrod character depicted in the TV series “Billions”.
How To Conquer The Psychology of Investing
The human mind is a very complex mechanism and it’s very easy for most people to make mistakes repeatedly due to misreading a situation or external pressures and temptation. Deluding oneself, being overconfident, having the wrong perceptions, seeking comfort from people that are in a similarly bad position, and having wrong perceptions- these are all the different mind traps that anyone can fall into.
So, stay sharp and be honest with yourself and think practically about your situation. And always ask well-informed experts from advice, who have enough integrity to keep it honest with you so that you can make the right, informed choices.