Many investors follow their gut and emotions when making buy and sell decisions, acting on emotional impulses when the stock market is volatile. It's easy to get entangled in fear or excitement as the markets ebb and flow, buying high and selling low. But acting emotionally isn't necessarily the best thing for your investment portfolio.
Even though many people realize it’s not the best strategy, it can be difficult to avoid emotional investing. Here are some behavioral traps that investors can fall prey to and our tips to avoid them.
The Short Version
- It's difficult to not act on emotion, but when it comes to investing, staying rational is key.
- If you want to avoid emotional investing, there are a few traps to look out for. This includes the Blindness Trap, Anchoring Trap, Sunk Cost Trap, and more.
- You can also employ good investing practices, such as diversifying your portfolio, plan ahead, and automate your investments.
Understanding Investor Behavior
If you’re a Star Trek fan, the model investor would be Mr. Spock. Leonard Nimoy’s famous character employed logic over all else while living an emotion-free existence. However, we’re not Vulcan. Avoiding emotion and focusing on logic in the stock market may not come as naturally to us humans.
In reality, it’s difficult to act rationally in the stock market, especially when there is market volatility. That’s why it’s important to invest based on sound financial plans with a long-term focus rather than taking on unnecessary risk.
For example, investors tend to follow the herd in investing. They listen to media and social media sources, buying on the way up, then sell on the way down depending on market prices. Anchoring, a common marketing technique, drives investors to place a specific value on something (perhaps a share of stock) even though it may have a lower or higher intrinsic value.
Investors also tend to be loss averse, doubling down on successful investments while hanging onto losers in the hope that they’ll turn around. These behavioral biases can cause investors to invest their money despite market conditions.
Those decisions should be led by financial and market performance, however, not your past performance. By understanding common investor behaviors and psychological traps, you’re in the best position for investing success.
Find out more >>> What is Behavioural Finance?
Psychological Traps Investors Should Avoid
While there are many regular missteps in the financial markets, these are some of the most common negative behaviors to consciously avoid.
Anchoring is an investment trap where you believe something is valuable currently because it was once valuable in the past, or seems closely related to something else of value. If you see something on sale at the store marked down from $49.99 to $29.99, you might think you’re getting a good deal at $29.99 because it’s “such a savings.” However, it could be marked down because no one else wants it, and it was never really worth $49.99 to begin with. That same thought process can lead to buying or holding overvalued stocks.
The blindness trap happens when an investor knows a stock is taking a negative turn but chooses to ignore the signals of impending peril. Think of this as a subconscious effort to ignore the truth.
The confirmation trap takes place when an investor looks to other individual investors going through the same thing for confirmation that they’re making the right choice. If you follow social media channels where someone posts that they’re holding onto a stock, and you then decide to do the same, you’re potentially falling victim to the confirmation trap.
Irrational Exuberance Trap
In the stock market, past performance is no guarantee of future performance. Irrational exuberance is a trap where investors get excited about a successful investment and buy more, even though the bulk of gains may have already happened. This is common when investing in a bubble, where prices continue to go up as irrational investors keep buying more and driving up demand. Eventually, that bubble may pop if the underlying asset doesn’t live up to the hype.
In some cases, investors limit market exposure when they feel confident about gains and take on more risk when worried about losses. That’s the opposite of what they should do in many situations. If you invest slowly in safer, long-term assets and load up quickly in riskier ones, you’re a potential victim of this psychological investing trap.
The relativity trap is the financial market equivalent of keeping up with the Joneses. If you look too much at other investors when picking your portfolio, you could unknowingly invest in the relativity trap. Just remember that your friends, coworkers and other Redditors are not you. These people may not have your best financial interests at heart or consider your financial goals when picking their investments.
With the superiority trap, investors think they’re smarter than everyone else and will outperform other investors. However, even the very best active fund managers underperform the markets. If professional investors can’t consistently beat the markets, we shouldn’t have the hubris to think we’ll do better when investing part-time.
Sunk Cost Trap
If you play Texas Hold ‘Em poker, you know the sunk cost trap well, even if not by name. When you’ve bet consistently throughout, hoping to get that perfect hand on the last card and don’t get what you’re hoping for, should you keep betting despite a probable loss, or should you keep betting? Even when you know you’re holding a losing hand, continuing to bet because you’ve already committed funds is an example of the sunk cost trap. When you hold onto losing stocks or buy more of them because you’ve “already committed,” you’re possibly making the wrong choice.
Read more >>> How to Stop Worrying About Short-term Investment Losses
6 Ways To Avoid Emotional Investing
- Plan ahead for bear markets: Markets go up and down. Plan for down periods so you know how you’ll respond rather than following knee jerk reactions and making emotional decisions you'll regret later.
- Build a diversified portfolio: Building a diverse portfolio, including buying low-cost index funds and using dollar cost averaging, can help you avoid the traps of buying and selling single stocks.
- Avoid checking your stocks too often: Most investors should be focused on the long-term. You don’t have to check your portfolio every day, every week or every month.
- Resist herd psychology: Don’t just follow the pack; use your own independent investment analysis and thesis when investing.
- Follow a passive investment strategy: Dollar-cost averaging and other passive, long-term investment strategies help you avoid many of the most common investment pitfalls.
- Automate your investments: Automated recurring investments take much of the psychological decision-making out of the investment process.
Remove the Barriers to Successful Investing
The best ways to overcome common investment traps and master your investing psychology revolve around awareness. Understanding investor psychology and staying focused on your long-term investment goals can help you notice any biases or pitfalls in your portfolio construction.
If you find yourself making mistakes, don’t be too hard on yourself. It happens to the best of us from time to time. Encourage yourself to remain objective. Stick with systems to invest strategically. Monitor your performance, handle losses well and become an expert in the investment strategies you’re using. In that case, there’s no reason you can’t find your way to investing success.
Time in the Market Usually Beats Timing the Market
There’s a famous saying that “time in the market beats timing the market.” Active investors who buy and sell frequently and passive investors who try to time market ups and downs often see lower long-term results than those with a boring, long-term strategy where they stay invested.
If you automate and stick to logic over emotion, you’re using a winning combination that will hopefully lead to abundant investment profits.