Psychology in the stock market: 5 behavioral failures and 5 ways to bypass the traps of one's own psyche

YEREVAN, May 3. /ARKA/.  Competent market participants take into account many factors when making transactions and stick to premeditated plans. However, even they sometimes act irrationally, not to mention investment novices. Why do investors forget about their own benefits and strategies? In many cases, this is explained by the mechanisms inherent in human nature.

Let's understand the reason for behavioral “failures” and their impact on investors' actions.

Key trends and rationale

1. Refuse to make decisions on their own, relying on the actions of others

You probably have an idea of the essence of such phenomenon as herd effect. People tend to follow the majority. In the stock market, this principle holds true. Investors, even experienced and knowledgeable ones, often look at the behavior of other participants and do the same.

One of the most famous examples is the situation related to “Black Monday”. This is the name given to the event of October 19, 1987, when the biggest decline (22, 6%) of the Dow Jones index in its history occurred. This event affected not only the United States, but spread around the world. In the run-up to that day, a massive sell-off in stocks began due to negative expectations. In a few days it became chaotic and led to the largest stock market crash in history. Even professionals, who realized in advance that the downgrade would happen, could not decide to sell assets.

Why is it difficult for investors to take actions that deviate from majority behavior? Here, most likely, fear for reputation comes into play. In the case of Black Monday, investors waited until the last minute to avoid missing out on profits and looking ignorant in the eyes of others. At the same time, they were ready to take a bigger loss at a time when everyone would face it.

2. Follow familiar paths

In order to solve tasks in the midst of a huge flow of data in the most “painless” way, our brain uses different techniques. One of them is the availability heuristic: people make decisions based on the first information that comes to mind. The conscious mind is not ready to face dissonance and accept knowledge that does not match what is already available. This leads to ignoring proven facts.

The “trap” is that we substitute our understanding of the real situation with the image that has already formed in our perception. So, we stop analyzing, constantly repeating familiar patterns of behavior and making the same mistakes.

Investors' actions can reflect this characteristic in several ways:

- When choosing securities, market participants prefer supercompanies often mentioned in mass media. At the same time, statistics shows that they are often inferior in financial indicators to smaller and less discussed players.

- They are based on bright and publicly available publications. Many cases illustrate that even the post of a significant person in social networks can influence the attractiveness of shares. For example, in 2016, Ilon Musk posted on his page that Tesla's Model 3 was not working with Samsung, as rumors had suggested, but with Panasonic. Within five days, the capitalization of Samsung's SDI unit fell by $580 million, Panasonic's - increased by $800 million.

- Do not go beyond the boundaries of familiar experiences, not always even their own. For example, a person decides that investing will lead to negative results after hearing about a friend or colleague who has experienced losses in the stock market.

Thus, investors limit their own opportunities, often do not measure steps with their own goals and lose profit.

3. Holding on to assets while missing out on benefits

People have a hard time parting with things they've owned for a long time. Emotional attachment comes to the forefront and the real value is diminished. The longer we own an object, the more it “fuses” with our self-image. An attitude appears: the thing will disappear, and with it a part of our personality.

In investing, this behavioral feature leads to reluctance to sell assets and update one's portfolio. As a result, the owner of, for example, shares misses the moment for the most profitable deals and continues to keep them, even if the performance of the issuing company deteriorates.

4. Prefer short-term deals to long-term investments

People find it easier to take advantage of an opportunity in the present than to believe that a positive outcome is achievable in the long term. A time-delayed event is less “tangible” and the fear of missing out on gains is too strong. Moreover, the stock market is not always stable, and this amplifies the effect.

As a result, even though they realize that buying assets for several years is likely to yield stable and large returns, many investors opt for “quick” trades. In addition, brokers profit more from this approach and often push clients towards it.

The effect is also seen in the dependence of the investment strategy on the age of the person. It is easier for young people to make a long-term investment than mature people, as they do not evaluate their risks as highly and are willing to compensate for possible losses over time.

By the way, remember: a day in childhood could last forever and was filled with a million events. And as we get older, we are more and more often tempted to say that the years “literally fly by”. This is due to the naturally changing perception of time.

5. Avoid recognizing losses even at the cost of lost gains

Do you know the feeling of wanting to compensate for a failure with a productive action as soon as possible? In response to this urge, people often rush into things and make bad decisions. This is a natural manifestation based on the effect of predisposition. Let's explain it with a simple illustration:

1000 and (2000 - 1000) are equal values. However, a person is more likely to prefer to get a thousand at once than to get two and then lose half of it. This is due to the peculiarity of our psyche: the pain of loss is experienced more strongly than the joy of gain.

In the field of investments, the effect manifests itself in such a way that participants refuse to record losses, hold unprofitable assets and try to close profitable positions. This is usually irrational and does not allow for capital appreciation. This mistake is characteristic of inexperienced investors. Participants who have made a large number of transactions understand more clearly that it is normal and appropriate to lock in losses.

Is it possible to bypass the “traps” of one's own psyche?

Of course, you can't completely remove yourself from the fear of loss and cognitive distortions. However, you can minimize the risks and prepare yourself for the consequences.

1. Make a financial plan and include probable losses in it. Then, in case of a negative scenario, you will not have to urgently close the holes created. Having allocated a separate budget line for potential expenses in advance, you will feel more relaxed and realize that you have made an investment in the future.

2. Expand your knowledge in the field of finance. Try to read various sources, follow the recommendations of several professionals at once. For example, from one you can learn how to set the right goal, from another - about effective diversification. It is good if you have the opportunity to read foreign publications. Many investors attend additional courses and seminars, turn to coaches.

At the same time, it is important to analyze the incoming flow of information and not to be influenced by rumors. Remember that experienced traders often introduce trends artificially in order to force newbies to make certain deals.

3. Create a financial cushion and replenish it regularly. This will be a way out in unforeseen situations. You will not have to forcibly restructure your investment strategy, abandon planned expenses or withdraw funds from your brokerage account. To ensure replenishment of the financial cushion, you can invest in conservative instruments.

4. Keep your own records of profits and losses. Even though you can get data from a broker, it is important to see and work with your results on a regular basis. Otherwise, it will be easier for you to give up analyzing, and over time this will have a negative impact. Start an Excel spreadsheet and make a schedule to pay attention to different parts and spread the busyness. Then analyzing won't seem overwhelming.

5. Do not give in to illusions about your own intuition. Successful deals are the result of an investor following the right strategy and taking purposeful actions. Take into account internal feelings, among objective indicators, when you analyze your risk tolerance. 

This material is prepared within the framework of the joint project "The Year of Investing in Oneself" by ARKA, AMI Novosti-Armenia news agencies and Freedom Broker Armenia.

Read the news first and discuss them in our Telegram

10:00 05/03/2024