Humans have about four to seven million years of bad investing habits to undo. You see, we’ve been hunter-gatherers for about 99% of our evolution, before we settled down with the advent of agriculture. And, unfortunately, as hunter-gatherers, we make for bad investors because of our natural response to fear and greed.
We used to be rewarded for these overcautious responses. Running at the sound of a peculiar noise meant surviving a dangerous predator. However, being an overcautious investor can mean missing out on opportunities. This happened to many investors after the major market decline in 2008/2009.
Along with being overcautious, there are other psychological mistakes humans are prone to when it comes to investing.
Overconfidence occurs when investors believe they can “time” the ups and downs of the market. It’s the most prevalent when we face a decision with a 50/50 chance. We generally have a higher expectation of success than we should.
Men, perhaps not surprisingly, tend to experience overconfidence considerably more than women.
“Those who don’t learn from history are doomed to repeat it.” This may be true, but for it to be effective, we have to take lessons from both the long-term history and the short-term.
Before 2005, insurance companies in the southern United States earned strong profits from low insurance claims due to many years of low hurricane activity. This led to lower premiums given the perceived low risk of future hurricanes.
Unfortunately, a little thing called Hurricane Katrina hit and many of those insurance companies went bankrupt because they had inadequate reserves. The hurricane itself was actually pretty predictable when looking at the long-term history rather than just the short-term.
“I’ll sell my shares when I get even.” Sound familiar? Investors contract get-evenitis when they are faced with selling at a loss, which would be admitting they made a mistake. Instead, they wait until their shares break even again. Unfortunately, attempting to get your money back the way you lost it isn’t much different in the stock market than it is in gambling — it usually ends badly!
Have you ever not liked a song when you first heard it, only to have it grow on you the more you listen to it? It’s human nature to be most comfortable with what is familiar. The same applies to investing.
Many countries struggle with the tendency to own a large percentage of securities within their own borders. It makes sense psychologically, as these are the places you shop, they’re companies you hear about in the news, or the ones that provide you with a service. It even happens within companies. Investing-wise, this phenomenon is very risky and will leave you at a loss when these securities fall.
Part of the reason that the housing market in the U.S. became such a bubble was because success stories were ubiquitous. Everyone’s cousin, coworker, or even your taxi driver had made money from buying property. It became universally believed that property would never go down in value.
This herd mentality happens when any hot trend catches the fascination of the masses. The key to sound investing is to take step back and look at each situation with a level head.
To avoid these psychological mistakes, make sure you identify which ones you’re most susceptible to and watch out for them. Having a well-defined strategy will also insulate you from these blunders, as you will invest according to your plan, not by feel.
This ends my series on the Five Investing Concepts for Financial Success. If you missed any blogs, check out previous posts on my website. Feel free to send me an email with any questions. Happy investing!