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Created on 25.09.2018

Psychological pitfalls to avoid when investing

If you’re investing money, you need to be as rational as possible when making decisions. Study factsheets, calculate key figures, consult your bank – these are all things we know in theory. In practice, however, it’s often a different story. Emotions, psychological factors and even gut instinct play a major role, both consciously and unconsciously. If you familiarize yourself with the main psychological pitfalls, you will be aware of the risks and you will avoid potentially losing assets. The return on your financial investment may even be better. We are going to lay out the main psychological pitfalls and show you how to avoid them.

“Overconfidence bias”: a limited number of selected shares as opposed to diversification

The singer who enjoys singing in their free time and decides to audition on a TV show – only to fail miserably. The friend who never asks for directions but regularly gets lost. Overconfidence is something we’re all familiar with. Investors also tend to overestimate their knowledge or the reliability of available information. They are too optimistic, and they believe they can “outfox” the market. This often means they rely on just one supposedly “good” share  rather than reduce the risks by diversifying . Investors frequently rate companies that they are more familiar with too positively. They might be relying on information provided by people they know, have already examined the company in depth, or they know the company from their own region. This quickly leads to investors giving preference to this particular company despite the fact a different investment would yield a better return.

The “bandwagon effect”: you (only) want to be part of the action when something is already popular

People generally follow the crowd. To put it figuratively: they love jumping on the bandwagon. The “bandwagon effect”, as it’s called, describes the phenomenon in which we would sooner be on the bandwagon that’s playing the music. Hype and most trends stem from this effect: this desire to belong. The same is true of the stock exchange. Lots of people prefer investing in securities that are also popular with other people. However, selecting securities based solely on their current popularity and ignoring analyses is a potentially risky move. What’s more, prices in companies and industries that are already all the rage are generally fairly high and so the chance of a return is low, at least in the short term. You end up merely going with the market. This can also be applied to investment activities. It would not be very smart at all to invest only when the stock exchange is experiencing a boom, i.e. a bull market, as this means you miss out on the growth phase.

“Hindsight bias”: distorted memories result in poor decisions

We all tend to overestimate the likelihood of an event if it has only just happened. It sounds complicated, but it isn’t. To put it simply: we’re always wiser after the event. A close couple gets divorced, a controversial candidate wins an election, a speculative bubble bursts – of course we all saw it coming. Instances of hindsight bias also play a role on the stock exchange: investors make (wrong) decisions about their financial investment because of distorted memories of successes and failures.

“Availability heuristic”: I base my judgement on what immediately springs to mind

Our memories distort information, which is something the availability heuristic demonstrates particularly well. The more unusual and terrifying the information is about certain events, the more deeply ingrained in our minds these events will be. This means we think the likelihood of this event happening to us is higher than it actually is.

To put it another way, which of these is more likely: dying from a shark attack or from an aeroplane part falling from the sky? Many people would expect it to be the shark attack, even though the falling aeroplane part is statistically far more likely. However, shark attacks feature more prominently in the media. That’s why most people think they pose a far greater risk. Even someone who has already been attacked by a shark believes the probability of being attacked again is higher than it really is. Our judgement can also be influenced by positive memories. Here’s an example: someone might invest in an equity fund with a focus on the African continent because they went on a lovely safari there and they associate positive emotions with the region. Financial investment should be based more on careful analysis than our own subjectivity. We should seek out and assess all relevant information rather than focus on the first thing that springs to mind and the emotional reactions it triggers.

Stay on the lookout for the psychological pitfalls that lie in wait. That way, you will reach analytically sound decisions that may even increase your return.

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