The Psychology of Investing

09/28/2022

Forget intellect! Whether you are a good investor or not has more to do with psychology and self-knowledge.

If we have to believe all experienced investors, psychology and emotion in investing is the most difficult part. This may also explain why economists or very smart people are not necessarily better investors at all. There is no relationship whatsoever between investment performance and IQ of an investor. Bad news for the smart ones among us. We think this is very positive for retail investors. We can all work on the bit of psychology and emotion. With a lot of self-reflection, we become much better investors over time, so we can properly compound experience.

Psychological pitfalls

The list could have been much longer. We have limited it to 6. It can be divided into two main categories of investment bias: cognitive and emotional.

  • Confirmation bias
  • Overconfidence bias
  • Recency bias
  • Loss aversion bias
  • Anchoring bias
  • Home bias

What we're not going to discuss: Don't fall in love with a stock, don't follow the herd (social confirmation), don't act out of stress, ego or impulsiveness, over-optimism and especially not timing.

Confirmation bias

It is normal for investors to be attracted to information that supports their existing views and opinions. Confirmation bias leads investors to place more emphasis on information that confirms their belief or supports the desired outcome. 

This can have a negative effect by reducing diversification and causing investors to overlook signals that it is time to adjust.

What can help minimise the effects: Provide yourself with up-to-date information gathered from various reliable sources. It is good to be fully aware of the pros and cons of your desired investments. This creates a more balanced picture that leads to better decisions.

Overconfidence bias

A common behavioural bias in investing is overconfidence, which causes investors to overestimate their judgment or the quality of their information. This can lead to 'doubling' a lost investment instead of knowing when to limit losses, or responding insufficiently to key information about changing market conditions.

To properly explain this effect, you can ask someone whether he considers himself a better driver than average. Most of the people say yes. That is of course not possible, 50% drive worse than the average. We see the same effect, for example, with the question of whether you are better than your colleague or act more ethically.

What can help to minimise the effects: Continue to develop yourself and stick to a solid investment plan and rebalance based on the actual market conditions.

Recency bias

Recency bias is a cognitive bias that favours recent events over historical events. Investors with a bias towards recency tend to overvalue the most recent information relative to historical trends.

For example, recency bias can threaten investors' financial well-being by encouraging them to become more risk-taking after experiencing favourable gains in their portfolio. It can also happen when the investor incurs an isolated loss and decides not to make any adjustments to the portfolio for fear of further loss.

What can help minimise the effects: Focus on the long-term performance of your portfolio by assessing both historical and current performance.

Loss aversion bias

In order not to face the loss, investors postpone selling stocks that are in the negative. Investors are deaf to negative news, causing a greater loss than necessary. On the other hand, profits are realised (too) quickly.

Research has shown that people feel the pain of a loss about twice as often as the pleasure of an equally large gain. This can lead investors to focus more on their investment declines than on gains, and can lead to passivity that stalls the growth of their portfolios.

What can help minimise the effects: Accept that losing money is an inevitable part of investing. As part of your strategy, you draw up a financial plan with predetermined exit strategies. As a result, you never stay in a loss-making share for too long.

Anchoring bias

Anchoring bias is the tendency to "anchor" in the first bit of information received rather than evaluating the market as new information emerges. For example, when investors anchor their belief about a stock's value at its initial trading price rather than current market conditions, it can lead to unwise decisions that can hurt the profitability of their portfolio.

This adjustment of an estimate occurs, for example, if consumers have to form a price judgment, and they are guided by a suggested price. This is a well-known marketing trick in stores and web shops.

What can help minimise the effects: Try to assess investments based on current market value.

Home bias

Finally, investors often have a home bias. Because we think we know more about French companies, a large part of the portfolio is filled with French equities. This leads to a lack of diversification and unnecessary exposure to the French market. This is especially annoying if the French market lags behind other investor markets.

The following aspects are mentioned as causes for the home bias.

  • Transaction costs are often cheaper in your home country.
  • Access to information is relatively good compared to foreign markets.
  • There is no exchange rate risk if you invest in your own currency.
  • Double taxation including dividend, fortunately Belgium has good treaties so that we are less affected by it.

What can help to minimise the effects: Define well in advance how much percent you want per currency and region. This prevents you from unconsciously building up a portfolio with Belgian shares in euros.

Self-reflection

You can forget the idea that you as an investor will not make mistakes. You are already doing well above average if 6-7 out of 10 stocks achieve a positive return. So even the best investors make mistakes. Of course, nice thoughts that even the very best investors still make mistakes. If you continue to learn from your mistakes, you will reduce the chance that there will be more in the future. Always try to find out why you made certain choices so that you can look at them again later with more information. Therefore, write down carefully why you buy a share.

Wouldn't it be better to invest without emotion?

Research has shown time and again that especially novice investors often buy at the top and sell with a fall. If you want to achieve good results, you have to do the opposite, act contrarian!

  • Create an investment strategy and stick to it
  • 'Dollar cost averaging', periodically buying more and building up your positions step by step
  • Invest diversified and not too much in one stock
  • Never buy a share immediately, wait at least 24 hours

This may also be the reason why more and more investors have started index investing?! And why expats let their money manage by performance fee-only financial advisors.

We specialise in helping expats to plan and invest their wealth and enjoy retirement without the stress of money. Contact us today for a no obligation conversation: hello@expatwealthatwork.com