Many experts have written on behavioral traps that mis-lead people. Some kinds of dysfunctional psychology are very evident in investor behavior. Some common psychological traps that harm investors have been identified by behavioral finance experts applying cognitive psychology findings to investor behavior, to highlight missteps. Several of these biases or “traps” are identified, such as anchoring to arbitrary numbers or being overconfident. We analyse several common traps faced by investors and try to overcome them.
This trap basically is over-reliance on what one originally thinks. Any metric is meaningless when taken out of context. If perceiving a certain company as successful, you may be over- confident that its stocks are a good bet. This could be totally incorrect in the prevailing situation or somewhere in the future. Remain flexible in thinking and open to latest information, as the reality is that the company may be here today and gone tomorrow. Some factors reduce anchoring effect, but cannot avoid altogether, even if aware of bias and seek to avoid it.
Sunk Cost Trap
The sunk cost trap is dangerous as you psychologically fail to protect your previous decisions disastrous for investments. Making losses is difficult as is accepting having made wrong choices or allowing somebody to make them. With a dud investment sinking fast, the quicker you disinvest the better. Never cling to sunk costs and divert to other asset classes that move up faster. Emotional attachment to bad investments ensures things fall apart. The sunk cost trap ensures a tendency for people to irrationally carry on an activity or investment not worth completing, due to time and money invested.
Irrational Exuberance Trap
When investors believe that the past equals the future, they act as if no uncertainty exists in the market. But uncertainty never vanishes with market ups and downs, bubbles, overheated stocks, mini-bubbles, industry losses, panic share-selling in Asia and unexpected market events. Believing that the past predicts the future, signals overconfidence. If enough investors remain overconfident, irrational exuberance turns to greed and primes the market, making a huge correction inevitable. The investors who suffer are still all-in prior to the correction; and cocky that the bull-run lasts forever.
This is based on investors’ perceptions of risk as this will limit risk exposure if their portfolio returns are positive, basically protecting the lead, but seek more risk if bracing for a loss. So basically, investors avoid risk when portfolios perform well but seek risk when portfolios are sinking and don’t need exposure to more losses. This mentality arises about winning it all back. Investors are willing to raise stakes to “reclaim” capital, but not create more capital. How long can a race car driver survive if using brakes only when he leads?
The Bottom Line
Human psychology is often dangerous, due to standard mistakes people commit again and again. It is easy in the heat of the moment, or if subject to stress/ temptation, to fall into such mind traps. Wrong perceptions, self-delusion, frantic hope to recoup losses, desperately seeking comfort from other victims, reality shut-outs and more, could cost dearly. Beware of these traps and if honest and realistic about yourself, and seek advice from competent and knowledgeable people of integrity as a reality-check before it is too late.