9 Psychological Traps to be avoided by Investors

Investors

Shares also have prices like all other assets. The share price is the monetary exchange value in the transaction. The difference between the Purchase price and Sale price is the gain or loss to the investor.

Investors always invest with the hope of better returns, which may be in the form of dividends (issued by the company)  or capital gains (the difference between the selling price and buying price). Rational judgment, enormous research, analysis of circumstances are required to determine the timing of selling to make capital gains.

Psychological Traps to be avoided by Investors!

Manier times information of the company, industry, dynamism of the economy may not be analyzed by investors and are prone to fall for psychological traps. Lack of confidence, fear of missing an opportunity, irrational behavior, loss aversion, following the trend, makes investors fall into the trap and lose their money.

Do you know why share prices change?

Like other assets, share prices are also affected by demand and supply mechanisms. Demand for a company’s shares accelerates the prices and leads to a bull run in the market.

On the other side excess supply of shares exceeding demand can exert a bearish trend, and crash the share prices. 

There are numerous micro and macro factors, influencing the share price of a company. Dividend declaration, Bonus issues, Rights issues, the appointment of directors, an announcement of mergers and acquisitions, investment in new profitable ventures, etc.

Related; Forces That Move Stock Prices

A thorough fundamental analysis of the company helps us to determine the accurate intrinsic value of the share.

All this analysis for an investor requires enormous efforts and time to work through possibilities of risk and return. Rational investors conduct detailed study discounts information of the company on the share price.

But the human brain likes short cuts, works on instincts, and follows the behavior of others, which is called herd behavior. This irrational behavior lacking the confirmation of the data, hindsight may create a bubble in the market. Market sentiments, emotional bias, herd behavior dominates over rationality

“I’m not emotional about investments. Investment is something where you have to be purely rational and don’t let your emotions affect your decision making – just the facts.”

-Bill Ackman

 

The following 9 psychological traps to be avoided by investors.

1. Anchoring trap

If you are making your decision on the basis of any particular event or past data or reference points, then the past data is called an ‘anchor’ and the process is called anchoring.

Assume that Mr. X  invests Rs 2,000 in Good Luck company and he earns a 20% return on his investment, which he expected. He gets this return for continuous five years and he is very content with the rational choice.

In the 6th year, the Stock market is indicating that the share Price of Good Luck is expected to fall and bears are dominating in the market.  

But Mr. X is not ready for disinvestment, as he got steady returns for the past five years. Here he is not open-minded to analyze facts and revalue the share price, past events are affecting his judgment, where decisions are anchored.

“The Investor of today does not profit from yesterday’s growth”

-Warren Buffet

 

2. Sunk Cost trap

Psychologically most of the individuals do not acknowledge their previous wrong decisions. If an investor holds an underperforming stock in the long run due to the buying decisions made earlier is called ad Sunk Cost.

In this case, the investor is anxious about the initial cost incurred in buying a stock, in return, the investor retains the shares with the hope of bull price in the future.

 

3. Confirmation trap

In this trap, investors retrieve, gather, and assimilate data that support their views or opinions and ignore the counter-arguments. They are not ready to absorb the facts of the other side.

They are biased for their thoughts and arguments and persist to collect data confirming their views and hence they are prey for the confirmation trap. A thorough analysis of either side’s arguments is required for a rational, unbiased judgment to avoid this trap. Overconfidence in their choice closes their door to other potential opportunities.

 

4. Blindness trap

The Blindness trap exhibits ignorance of market situations. These kinds of investors await for their streak of luck to play and disregard the prevailing market conditions. They take no notice of unavoidable losses instead keep their blinders on.

Investors hold the share blindly irrespective of the underperformance of the stock or market warnings or a major scandal in the company.

“Never adopt permanently any type of asset or any selection method. Try to stay flexible, open-minded, and skeptical.”

– John Templeton

5. Irrational Exuberance trap

Irrational means senseless or illogical and exuberance implies excitement or cheerfulness. In the stock market, if investors are trapped due to their overconfidence from the past experience,  ignoring fundamental facts, it is called an irrational exuberance trap.

The prices quoted by investors may not be supported by fundamentals. Rigorous analysis Company’s fundamentals and valuation of securities can save investors from this trap.

 

 
 
 
 
 
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6. Pseudo Certainty Trap

This type of investor’s focal point is to secure their capital investment. The ideology of these investors is to take a higher risk during the bearish trend and take the lower risk during the bullish trend in order to secure the capital invested.

Generally, during the downfall investors exit the market by not taking a further risk, but investors with pseudo-psychology tend to buy more shares during the downtrend with the hope of capital appreciation. Whereas, during an uptrend of the market they hesitate to buy more shares.

 

7. Information overdose trap

Data is the fuel for decision making. Financial well-being has an impact on the contentment of the individual. Any investor who would perform a thorough analysis of past data, current situation, and based on future benefits will invest in the instrument.

In order to be prudent in decision making, they start collecting enormous data where they find relatively new data from each source and finally fall into the Information overdose trap. Collecting excess data will lead to confusion and tends to make the wrong decisions.

This has a deleterious effect on the confidence of investors. Gathering the right data and setting limits to collect data, will help investors avoid this trap.

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8. Status-Quo trap

Ideally, the meaning of the Status quo is “the state of affairs that existed”. As the meaning suggests, investors with this thought process will not do any research on new stocks instead they buy shares by following the herd or buy the shares which are well established in the market. These kinds of investors do not involve in value investing.

Sins of commission are more punished than sins of omission. In an error of commission, the investor selects the wrong stock, whereas in an error of omission the investor will ignore the profitable portfolio. As doing something is punished but doing nothing is not punished.

9. Relativity trap

Investors are into this trap due to comparison. When they see other portfolios earning higher returns than their portfolio, they tend to change their strategies, fund allocation, assets, etc.

As each investor’s priority, risk appetite, and return expectations are different from others, it is always crucial to match investment strategies with the objectives. Mere comparison and reallocation will not help in achieving an individual’s financial goals.

Summary:

Type of trap

Why do investors fall into this trap?

How to avoid this trap?

Anchoring trap

High emphasis on past data

Current facts are to be given higher prominence

Sunk Cost trap

Past cost is considered in investment

Past cost data has to be ignored and look forward to the future returns

Confirmation trap

Biased decision making due to the comfort zone

Investors have to be open-minded and make a neutral evaluation of alternatives

Blindness trap

It is because of blind faith or earlier experiences 

Rely upon current updates from reliable sources

Irrational Exuberance

It is an emotional excitement 

Do an in-depth analysis of facts

Pseudo Certainty

Loss aversion and wants to secure the capital

Market movements and waiting for the right time to invest

Information overdose

Lack of confidence

Filtering sources and limiting the collection of information to the reliable source

Status Quo

Following the herd behavior

Thorough fundamental analysis of the stock to ascertain the intrinsic value

Relativity Trap

Comparison 

Align your investment goals to portfolio selection

 

As rightly mentioned by Father of Value Investing, Benjamin Graham “Individuals who cannot master their emotions are ill-suited to profit from the investment process”.

Investors’ fear, enthusiasm, loss aversion, ego or overconfidence, etc are their emotional barriers in the path of a successful investment journey, overriding the rational judgment.

What do you think!

Ramya N & Chaitra Karanth
Ramya N & Chaitra Karanth both are Assistant Professor at NMKRV College For Women. Ramya N has 7 years of experience in teaching. Chaitra Karanth is skilled in Microsoft Word, Public Speaking, Teamwork, and Microsoft Excel. Strong accounting professional with a Master of Finance and Accounting (M.F.A.) focused in Accounting and Finance.