Investing is a difficult sport. It is probably one of the most competitive businesses in the world due to the number of players. And just like physical sports, talent alone is not enough for long-term success. Players must have a strong mental game to compete at the highest levels. This is where psychology comes into the picture—a growing field more commonly known to the investment world as behavioral finance. Let’s explore a few of the main psychological barriers to investment success.
Something from Nothing
Most people are drawn to the financial markets because of the prospect of making money with very little effort. Unfortunately, it’s just not that simple. Investing requires a lot of work—a lot of reading and a lot of thinking. And just like any other profession such as sports, medical, or legal, one should not expect to just walk into the field and enjoy instant success. What advantage could a newbie expect to have over someone with specialized training and years of experience? Inevitably, this desire to make something from nothing leads to speculative behavior and financial ruin.
When faced with adversity, we all have instinctive responses. Sometimes we run for cover and sometimes we face the challenge with brimming confidence. In investing we often buy something that drops precipitously and we are faced with such a challenge. A rational investor will reevaluate the situation and make the most logical decision. However, an emotional investor will either fight (effectively double-down in hopes to recover the loss), or will set flight (sell immediately without regard to fundamentals). This fight-flight response is especially powerful in market crashes. Many investors sold in panic from October 2008 through March 2009 when, in fact, this was one of the best buying opportunities in modern times. Some may argue that this is only known in hindsight, but there is a long list of value investors who have documented this sentiment in conference calls and shareholder letters. They were being rational.
Many psychological studies have shown that people are about twice as receptive to pain stimuli as opposed to pleasure stimuli. This is similar to a child that touches a hot stove and burns his hand. The child is highly unlikely to touch a stove again, even if it is not hot. We also see this with an investor who speculates in stocks and loses a lot of money. Even though the error was in the speculating and not from stocks in general, the investor may associate the pain with stocks and mistakenly avoid stocks all together in the future. When faced with potential pleasure (profit) and a repeated painful experience (loss), we are more likely to pass in fear of another painful experience.
Natural Pattern Seekers
Let’s face it; we can’t help ourselves from seeking patterns. Most people think of this in terms of technical analysis, but value investors are pattern seekers as well. We have found a pattern that shows a high probability of success when buying investments that offer cheap assets or cheap cash flows. This skill was extremely helpful in ancient times, when humans traveled through the wild. If there was a rustling in the bushes and then a tiger jumped out and killed someone, the people of ancient times would not hesitate the next time they heard a rustling in the bushes because the pattern told them that rustling in the bushes equaled deadly tiger. However, this skill is not as helpful in the investing world. If we enjoy success, we often look for the same quantitative or qualitative pattern rather than looking for the underlying reason why we had success.
Mistake Correlation and Causation
Logically, this makes no sense at all, but we do it all the time in the investing world. This is why we hear things like “the January effect,” which says that the direction of the market in any given year will follow the direction of the market in January. January is not causing the market to go up or down. We also see this in other false axioms such as “sell in May and go away,” suggesting that investors should cash out in May and wait for the summer to pass before reinvesting. And because notable market crashes have occurred in October, many investors mistakenly believe that they should avoid being in the market during October in order to avoid any market crashes. The only pattern that may be more causation than correlation is the presidential cycle. This is because late in a presidential term, there is less uncertainty over the direction of policy. Markets punish uncertainty, which is highest around major political changes.
Mistake Uncertainty for Risk
This is also very common. Many investors will sell securities that have a high level of uncertainty. However, uncertainty is not the same as risk. Uncertainty has downside and upside potential, while risk only has downside potential. There are sometimes investment opportunities that offer low risk, but high uncertainty. These can be some of the most wonderful investments.
This is probably what created a lot of repeat offenders in the technology and real estate bubbles of the past decade. Wild bull markets attract novice investors because of the cocktail and neighborhood conversations about easy money. Often, the novice makes an investment in the latter stages of the bull market and enjoys early profits (on paper). These early gains give the novice investor a false confirmation of his investing skills because the gains were more of a result from simply being in the market than investing acumen. Naturally, the novice invests more and more into the final stages of the bull market because he continues to receive further confirmation as the market goes higher. When the market tops and begins to turn negative, the novice’s early success gives him the confidence to hang on to these losing investments until it is too late and he suffers a permanent impairment.
When people are asked whether they are above-average drivers or below-average drivers, an overwhelming majority say they are above-average. Obviously, this can’t be. This tendency to overstate our abilities is found in investing as well. After all, why would someone continue to invest while admitting they are below-average? While most people believe they are better investors than the average, studies have shown that over long periods of time (10+ years), less than 25% of all investors are able to beat the market index, which is essentially the average before expenses.
Home Town Bias
Very similar to the good driver problem, many investors suffer from home town bias. Everyone thinks that their home town is the best, their state is the best and their country is the best. This directly translates to investing as well. A domestic small cap manager may believe that domestic small cap stocks are always the best investment. Most investors (especially value investors) know that this is simply not true. Good investments are a function of risk-reward, which is dependent upon the price paid. Domestic small cap stocks are not always the cheapest. Sometimes it’s real estate, or emerging markets, or corporate bonds, or cash, or whatever. It’s easy to believe that the best opportunities are always in the area in which we have special expertise, but good investors know better.
This is only a short list of the potential psychological pitfalls that get investors into trouble. By simply overcoming these barriers investors will be ahead of the game. Talented prospects in professional sports are exciting because of their great potential, but only those who master the mental game go on to be superstars in their respective sports. Master the mental game and turn your potential into success.
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Disclosure: No positions