Investing — How to use psychology

We are all human beings and investing is a game of whit against your own emotions and psychological perceptions of an investment. This article attempts to give you the tools to be a better investor by understanding your natural flaws.

When it comes to investments it is our natural tendency to bring our emotional states into our decision-making process. It is the understanding of these psychological impediments that will make you a better investor and in turn, make you more money and minimise losing money.

The sunk cost fallacy

You may have done your research before investing in for example a stock or property and found out the investment is worth putting your money in, however, down the line, this evidence you had in the past is no longer relevant in the present. Putting more money into the investment is felt as a justification for your efforts and will eventually reap a return.

“Insanity Is Doing the Same Thing Over and Over Again and Expecting Different Results” — Albert Einstein

Just as Albert Einstein said in the quote about insanity, the insane thing for you to do is to pour more money and effort into an investment when all evidence shows the investment will lose you money. How you overcome this is to make sure you are guided solely by the evidence. A bad investment is a bad investment and will not change however much time, effort and/or money you invest in it.

During my early days of investing, I fell into this trap of the “sunk cost fallacy” and learning from my own mistakes was vital to regain my losses and minimise other future investment losses.

Emotional attachment to objects

The sentimental value of an object evokes a powerful emotional connection that we may have with an object. Some people are natural hoarders and although such an object has little intrinsic value to it either emotional or in monetary terms, it is retained, kept and impossible to let go of. In investing this can be seen as an issue when you hold such an investment for a long while you may subconsciously look at it as an object that you can not let go of. Your emotional attachment prevents this from happening.

The “fear of losing” such an investment can bring anxiety and stress to the investor and in turn, be seen as losing part of your own identity. There is also the “perceived utility” to the investment where the investor will justify the investment from its perceived value or utility. Lastly, there is the “sense of control” in keeping such an investment good or bad, letting go of the investment makes you feel a loss of control and by extension your environment. You can overcome these impediments by keeping an eye on your investment goals and most importantly the present evidence on the investment. Is it a good investment? great keep it, bad, get rid of it.

Importantly your investment evidence for your initial investment may change in the future, remember do not be attached to that evidence too rigidly, it is a guide and changeable over time.

Loss aversion

Investing of course is all about making money and not being in a position where you lose money. You can learn from your mistakes but investors by their nature feel pleasure in the gains and feel down on the losses. The loss aversion bias is where investors will feel far greater pain in losing money than pleasure in the gains of making money. Being aware of this can greatly improve your chances of making money and prevent you from keeping hold of an investment when it is losing you money.

The important element to this is to remember that not all investments that go down are bad as the evidence may show it is a good investment to hold and keeping it will make you money down the line. Evidence is crucial and never be swayed by other people’s opinions towards the investment.

Confirmation bias

Investors can become tunnel-visioned into seeking out the information that confirms our decision process and investments are not immune to this. In investing it is important to seek out the evidence to dismiss your findings not just to assert your decision-making. Being conscious of this potential confirmation bias will solidify that evidence and prevent it from showing a false positive.

Herd mentality

“Be fearful when others are greedy and be greedy only when others are fearful.” — Warren Buffett

Some new investors tend to invest without any research into their investments and seek out those potential investments from what others have been investing in having a fear of missing out. Humans are creatures that tend to look to others and as such follow the herd. This is a natural tendency that we must avoid at all costs. In doing so we risk losing the money that we have invested which is equivalent to placing a bet in a lottery. Good and thorough research is the cornerstone of any decent investor.

Take for example the Dotcom bubble that started in March 2000 and unravelled in October 2002. The bubble started with the Nasdeq running at 5,048 and then ended its low at 1,139 a massive fall of 3909 points in just under 2 years! this is a prime example of the herd mentality. People flocked to the next big thing in the tech world yet proper and thorough research would have prevented those investors from losing huge amounts of money.

In late 2021 a company called GameStop based in the US increased its share price by a whopping 700% from a frenzy of tipsters pushing up the price through social media, it later crashed by 55% of its value. The hedge funds predicted the fall and shorted the stock making them a lot of money in the process but, the investors in turn lost a lot. Another prime example of herd mentality.

Take note of what Warren Buffet said in his quote “Be fearful when others are greedy…”.

In conclusion, be conscious of your own psychological and natural biases that will prevent you from making money. Investing is a matter of the facts at both the time of the initial investment and throughout that investment’s lifetime. Do not be swayed by what other people say, nor be deterred when you see a company stock fall as fear from others could be a catalyst to make money but again only decide on an investment from the “facts” at the present time.

Important Disclaimer: I am not a financial advisor, nor am I an investment advisor. All information contained within this article is from my personal experiences over the years with investing. Remember, unless you invest cash with a financial institution such as a bank on a fixed interest rate then you could get back less or even none of the invested money.

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