Psychology is a central pillar in investing.
You may be surprised to learn that there are multiple ways our minds can play tricks on our minds when it comes to making good investment decisions.
There are two categories of psychological influences which can impair judgement and wreak havoc on our investment process.
The categories are fallacies and illusions.
Fallacies are mistaken beliefs based on flawed arguments.
Illusions refer to a distortion of our senses that warp our perception of reality.
We focus on three kinds of illusions which investors should be wary of.
Illusion of control
When it comes to money matters and investing, the illusion of control seems to manifest itself fairly often.
For instance, investors tend to overestimate their ability to control events or outcomes.
In reality, investing is a probabilistic exercise where we need to rely on insights and analysis to shape our investment theses.
It is also an exercise where we should focus on the process, rather than outcomes.
Investors suffering from the illusion of control feel that they can control the outcomes of their investment decisions when in reality, there are myriad factors at play, including luck.
Having the illusion of control may cause an investor to feel over-confident and plough too much money into an investment idea, with the erroneous assumption that he or she can influence the investment’s outcome.
Jumping to conclusions
Jumping to conclusions is a case of investors believing that they possess superior knowledge, which leads to shortcuts when making investment decisions.
There is also a tendency to put too much weight on the information we have obtained through hard work.
In this case, we may feel the urge to justify our effort after spending time and effort on extensive research.
Justifying time spent on a task is also reminiscent of a fallacy known as the sunk cost fallacy.
The sunk cost fallacy makes an investor reluctant to abandon an idea or train of thought because he or she has invested heavily in it.
Armed with what we believe is “superior” knowledge, we may let our guard down and jump to quick and easy conclusions that may be inherently flawed.
Jumping to conclusions will usually lead to poor investment decisions as the analysis may be one-sided and biased if the investor does not engage in an open and frank discussion on the pros and cons.
Clustering illusion
Clustering illusion is the belief in the existence of patterns where none exist.
This psychological illusion is usually present for practitioners of technical analysis (i.e. chart readers), who claim they can identify stock market patterns within the lines and squiggles of price charts.
The mind can conjure up wonderful patterns even though none may exist, as the brain is wired to try to make sense of random information.
I will not go so far as to say that a chart reader is delusional.
But the brain does frequently play tricks on us by leading us to “see” patterns among seemingly random, unrelated phenomena.
Just think of how you can somehow see familiar faces or shapes when you look at clouds floating in the sky, and you can get an idea of how prevalent this illusion is.
If investors assume patterns that are not present, it could lead to dangerous investment decisions that put their money at the risk of permanent loss.
Get Smart: Be aware and be careful
It’s almost impossible to completely avoid being tripped up all or some of these illusions.
That is the case even if you are aware of these mental shortfalls..
Investing is a relatively recent activity for the human brain, and the proper and correct process is not automatically hard-wired into our genes.
In short, it can be a “mind-field” out there where you need to step carefully or risk “blowing up” your investment portfolio.
The best thing you can do is to be both aware and wary.
Bounce your ideas off a trusted fellow investor, while also going through the facts and numbers to ensure you don’t get caught up in the above illusions.
Want to ride the stock market recovery? Download your FREE report: 3 Stocks I will buy in 2021! It comes with a bonus 3 trends for 2021, so you will be well equipped to ride the stock market recovery in 2021. Click HERE to download now!
Follow us on Facebook and Telegram for the latest investing news and analyses!
Disclaimer: Royston Yang does not own shares in any of the companies mentioned.
