How Emotions and Biases Can Hurt Your Investments
Investing is not only a matter of numbers and logic, but also of psychology and emotions. Benjamin Graham, a famous investor of the 20th century, realized that our own feelings and prejudices can often be our worst enemies when it comes to making sound investment decisions. Modern research has confirmed his insights and identified some of the common emotional and cognitive biases that can affect our judgment and behavior in the financial markets.
In this article, we will briefly examine some of these biases and how they can harm our investment performance.
Fear and Greed
These are the two dominant emotions that drive investors and markets. They can cloud our ability to think rationally and objectively. When we are fearful, we may panic and sell our assets at a low price, or avoid investing altogether. When we are greedy, we may buy overpriced assets, or chase unrealistic returns. Both emotions can lead us to ignore the fundamentals and the risks of our investments.
A famous example of fear and greed in action is the tulip mania of 1636, when the prices of tulip bulbs in the Netherlands soared to absurd levels, driven by speculation and frenzy. The bubble eventually burst, leaving many investors bankrupt. Another example is the credit crisis of 2008-2009, when the collapse of the housing market and the financial system triggered a global recession and a massive sell-off in the stock market. Many investors lost a significant portion of their wealth and confidence.
The key to overcoming fear and greed is to have a disciplined and long-term approach to investing, based on sound principles and research. We should also be aware of our own emotions and resist the temptation to follow the crowd or act on impulse.
Overconfidence
This is the tendency to overestimate our own abilities and knowledge, and to underestimate the uncertainty and complexity of the market. When we are overconfident, we may ignore or dismiss information that contradicts our views, or take excessive risks without adequate diversification or protection. We may also trade too frequently or too aggressively, increasing our costs and reducing our returns.
Peter Bernstein, a renowned economic historian, warned that the most dangerous moment for an investor is when he or she feels that he or she is right. That is when we are most likely to fall prey to overconfidence and make costly mistakes.
The remedy for overconfidence is to be humble and realistic about our own limitations and the unpredictability of the market. We should also seek feedback and advice from others, and learn from our failures as well as our successes.
Selective Memory
This is the tendency to remember and emphasize the positive outcomes of our decisions, and to forget or downplay the negative ones. This can distort our perception of reality and our learning process. We may become overconfident, complacent, or biased in our future decisions, or fail to recognize and correct our errors.
For instance, we may remember the times when we bought a stock at a low price and sold it at a high price, but forget the times when we did the opposite. Or we may remember the times when our predictions were accurate, but forget the times when they were wrong.
The solution for selective memory is to keep a record of our decisions and their outcomes, and to review them periodically and objectively. We should also acknowledge and analyze our mistakes, and use them as opportunities to improve our skills and strategies.
Prediction Fallacy
This is the tendency to believe that we can forecast the future based on the past or the present. We may assume that there are patterns or trends in the market that will persist or repeat, and that we can exploit them to our advantage. We may also rely on rules of thumb or heuristics that may not be valid or applicable in different situations.
However, the market is often random, dynamic, and influenced by many factors that are beyond our control or comprehension. What worked in the past may not work in the future, and what seems obvious or logical may not be true or relevant.
A classic example of prediction fallacy is the “January effect”, which is the belief that the stock market tends to perform well in January, especially in the first week. Many investors have tried to profit from this phenomenon, but the evidence is mixed and inconsistent. Another example is the “hot hand fallacy”, which is the belief that a successful streak will continue or that a losing streak will reverse. Many investors have fallen victim to this fallacy, either by holding on to a losing position too long, or by selling a winning position too soon.
The antidote for prediction fallacy is to be skeptical and flexible in our thinking, and to test our assumptions and hypotheses with data and logic. We should also diversify our portfolio and hedge our risks, and avoid putting too much weight on any single factor or event.
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