These are 3 of the most common psychological investment errors (in my view) and how we can find solutions as investors to these with the aim of increasing returns and not being our own worst enemy - I don't need anymore holes in my foot!
1. Anchoring bias
Anchoring bias is when an investor relies too heavily on an initial piece of information they receive / find. For example, you're driving home from work and drive past your local dealership to see the car of your dreams for £50,000. The dealership closed 30 minutes ago so there is no sales manger to talk to. You decide to pull over and have a quick look around your dream car. You're completely sold, but you know the wife wouldn't be impressed as you're suppose to be paying for 2 holidays this year, renovating the house, and not to mention your kids University fees. The next day you finish work earlier and are driving past the dealership which is open for business. You notice your dream car is discounted by 20% to ONLY £40,000. Wow, what a bargain! I must go in and buy it as it's on offer. I can explain to the wife why we aren't going on holiday or renovating the house because the car was 20% off so how could I not have bought it! Right?
This anchoring bias relates directly to stocks and their share prices. How often have you heard it was £10 a share, now it's only £5. This is the anchoring bias directly in action. You're assuming that because the initial information of hearing it was £10 a share and now it's ONLY £5 a share it must be a bargain. This is a difficult cognitive bias to overcome as we're constantly suckered into purchasing things we never really wanted just because we put significant weight on the initial price we saw. How often do we go shopping just to 'browse' but come back having spent £100's. What's usually the justification for spending the £100's? Well, it was on offer of course! How could I not at these prices!
Hopefully you're beginning to see the flawed logic to this approach and how it could be destructive to stock market returns. If the rationale for purchasing a stock was because it was discounted (you consider it 'cheap') then if the price keeps falling you should keep buying, following the same logic. Not only might the share price never recover, the company could go bust. There is often a reason behind a serious share price decline that might not become known until much later.
What's a solution to the anchoring bias?
- Have an investment strategy not predicated on purchasing falling stocks (knives);
- You're investment strategy could have a checklist and one rule could be the stock needs to be in an uptrend.
2. Fear of Missing Out (FOMO)
We've all had it where someone has told us of a stock that is going to the moon - "buy now it's a sure thing" or "it'll multibag from here". Because of our FOMO we do little research and purchase the shares on a not so hot tip and see our investment depreciate in value.
FOMO also affects our thinking in several different ways such as causing these thinking behaviours:
- Makes us extremely confident and optimist;
- There might not be an opportunity like this ever again;
- This trade is the one it'll make me rich;
- I can't miss out again.
FOMO usually leads to over-trading and taking too large a position size - i.e., not controlling risk.
So what is the solution if you think your suffer from FOMO?
- Have your own system where you can generate your own trading ideas from - i.e., being self sufficient;
- Stay off bulletin boards / social media for trading ideas / advice;
- If you cannot generate your own trading ideas you'll need to educate yourself more and develop your own strategy.
3. Revenge Trading
Revenge trading is where your mindset is that you must make back previous losses. Usually investors try to do this by significantly increasing their position sizes and not controlling risk. They are angry at the market. Remember, the market does not care about you and does not owe you anything. It is a brutal arena.
What are some solutions to stop revenge trading?
- Your position sizes are probably too large and your losses hurt you emotionally, try scaling back position sizes;
- Stick to your system and trade logically, not emotionally;
- Begin increasing position sizes when you're back to winning ways - i.e., trade at your smallest when you're losing and at your biggest when you're winning - different systems will perform better in different market environments.
Also keep in mind the ultimate goal when investing/trading - moving the chart from bottom left to top right over time. Minor setbacks are a part of trading. You always need to survive to fight another day.
“If you don't bet, you can't win. If you lose all your chips, you can't bet.” – Larry Hite
Speaking for myself, I think the biggest barrier to achieving high returns is my psychological tenancies (pitfalls). When I started to work on my 'trading psychology' and understanding myself better my results started to dramatically improve. The thing I've been working on recently is not to revenge trade and instead follow my investing process.
In short, when I stopped doing dumb things and shooting myself in the foot I got better at trading!