Avoid These Four Common Psychological Traps When Investing

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By Molly O’Connor, International Banker

When it comes to picking that next stock winner, most of us wish that we could simply disconnect our brains and our senses from all the noise around us, objectively research and assess potential investment targets, and take a prudent investing decision as dispassionately as possible. With the rapid evolution of artificial intelligence (AI) tools within the financial-services realm, that may well be a reality before too long.

In the meantime, a fairly sizeable human component is still required within the investment decision-making process. And so long as this remains the case, investing will be subject to cognitive and emotional biases. These psychological traps invariably prevent us from making the impartial investing decisions that are necessary to maximise our potential gains.

With that in mind, here are some of the most common traps to which investors often succumb:

1. The Bandwagon Effect

A study was conducted at a US university in the run-up to the 1992 presidential election that pitted Democratic challenger Bill Clinton against incumbent Republican President George H. W. Bush. The group of students involved in the study was asked to provide their initial voting choices between the two candidates, with half the students being provided with polling data that showed Clinton firmly in the lead and the other half blocked from seeing the same polls. Upon seeing the polls, however, many students who originally signalled their intentions to vote for Bush switched their votes and chose Clinton instead.

The study was a clear example of the bandwagon effect, with students jumping on the more popular Clinton bandwagon. Also known as herd mentality, groupthink and consensus bias, the bandwagon effect can be just as potent an influence when investing—and can, therefore, be difficult to overcome or ignore.

Many of us feel more reassured about a decision when we know that many others have already made the same decision. Indeed, following the crowd can often feel like the safest choice. This is especially true when prices are more volatile—the “fear of missing out” can be palpable when everyone else is buying and prices are sharply rising, while failing to sell when there’s a broad sell-off and prices are falling can be hugely panic-inducing.

The solution to defying the bandwagon effect is simply to consistently avoid being part of the herd and to be more aware of the situations in which you might potentially capitulate to market groupthink. The temptation may be to do the diametric opposite of everyone else during such scenarios, but this type of contrarian mindset can be just as damaging, especially if your main justification for the investing decisions you take is to be deliberately contradictory.

As such, performing a detailed analysis of a potential investment target—that is, evaluating each investment on its merits—and prioritising that analysis over and above what others are doing remains the ideal method to keep the bandwagon effect at bay.

2. The Confirmation Bias

The confirmation bias, another hugely powerful influence on investing behaviour, explains the tendency of investors to value information that confirms their pre-held beliefs whilst ignoring information that challenges or outright contradicts those beliefs. In other words, this bias makes us likely to declare: “Yes! That’s exactly what I was just thinking” when we encounter news that supports our existing worldviews.

This bias can play a rather insidious role when we are researching potential investment opportunities. Whether because of our egos, emotions or something else, humans are hardwired to favour information that supports our beliefs. As such, it is a much more difficult endeavour to change our belief systems when we come across new, conflicting information or evidence.

Again, the confirmation bias plays a significant factor when it comes to our political stances. Those on the “left” of the political spectrum will value only the news sources that support their pre-existing political beliefs. Those on the “right”, meanwhile, will end up valuing entirely different news sources and publications to support their own political positions.

This concept widely extends to finance. You may have a firm view that soybean prices are heading higher over the next few weeks, which draws you towards demand data from the United States that confirms this bullish view. At the same time, however, you ignore key supply data from leading soybean-exporter Brazil, which provides strong evidence that prices will head lower. Or, at best, you might take account of the Brazil data, but you do not give it the same weight of importance as you do the consumption information coming out of the US.

This ultimately means that we gather information selectively and then interpret that information in a biased way. The absolute ideal way to repel this powerful bias when conducting investment research would be not to form any opinions or hold any beliefs at all.

Acknowledging the impossibility of such a task, then, the next best solution would be to not rush into making investment decisions. Instead, actively seek out information from sources and publications that offer counterviews and typically go against your worldview and beliefs. Find an opposing view to your own and give it due consideration. And try to evaluate all sides of an argument before deciding which is the best course of action.

3. The Expectation Bias

“Taste: A Study in the Representation of Chemical Substances in the Arena of Consciousness” was a dissertation study published in 2002 by Frédéric Brochet, a PhD candidate at the University of Bordeaux – II, France. The study involved 27 male and 27 female oenology students from the university, each of whom was offered a glass of white wine and a glass of red wine. Upon drinking their wine, the students mostly described the glass of white as flora, honey and peach—words that are commonly used to describe white wine. The glass of red, meanwhile, was described as raspberry, cherry, cedar and chicory.

Brochet invited the same students back one week later, when, once again, they were each given two glasses of wine. On this occasion, however, both glasses were, in fact, white wine, but one of the two glasses had been disguised as red wine, with Brochet secretly adding flavourless red food colouring to the white-wine glasses beforehand. Nonetheless, the 54 students all described the disguised white wine using such terms as raspberry, cherry and cedar.

By using such words to describe the “fake” red wine, the students exhibited what is widely known as the expectation bias—that is, the tendency to believe what our expectations and perceptions of situations lead us to believe based on the information that’s available about a particular situation or the outcomes of previous similar situations. By perceiving the red colour in the glass, the students expected to be drinking red wine when the glass actually contained white wine.

When investing, our expectations about the performance of a company or asset class can be starkly different from reality. A company may have performed exceptionally well in the first half of the year due to strong earnings, and the published financial data confirms this. But by no means does this automatically mean the same company will perform just as well in the third quarter of the year. When doing our research, we should not automatically expect strong gains for the subsequent quarter based on the performances during previous quarters—or, indeed, the same quarter a year ago—when, in reality, other data sources strongly imply that an underwhelming showing is in store for the third quarter.

It is worth remembering that past performance is no guide to the future when trying to address the expectation bias. It is thus worth referring to a wide range of relevant information sources when making investment decisions rather than simply relying on previous results.

4. The Seersucker Illusion

Has anyone ever said to you, “Trust me. I’m a professional. I know what I’m doing”? Did it fill you with reassurance? Or perhaps with dread?

As with most fields, the financial-services industry is replete with such “professionals” whom clients trust to provide them with accurate forecasts about the future. Indeed, large sums in fees often change hands based on the outlooks of these professionals.

When it comes to the daunting world of investing, seeking out a professional could well be the preferred route, especially if you are fairly new to financial markets. Having someone mentor you about the basics of investing strategies can be hugely helpful, if only to build your confidence to navigate this often complex space independently.

That said, employing experts should never be a substitute for doing your own research based on your investing preferences and risk profile. Excessively relying on the gurus—regardless of the industry or the situation—is known as the seersucker illusion. As the saying goes, “No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers”—or more simply put: “For every seer, there’s a sucker”.

Despite the evidence that the average “seer” is no better at forecasting the future direction of the market, the sucker will continue to pay for the seer’s existence. As such, overreliance on the views of these so-called “experts” could be just as hazardous as investing blindly. Whether they are investment advisors, brokers or even the loud, obnoxious investing “gurus” that appear on television and bellow out endless stock recommendations in front of the camera, once again, the best advice to avoid the seersucker illusion is to do your own research and your ownanalytical thinking.