When we make choices about how to invest, we almost always do so ‘under the influence’. Not under the influence of something dodgy, of course, but under the influence of our own ingrained cognitive biases.
Our psychology plays a deep-rooted role in our decision making. And when it comes to investing our money and time, that can be dangerous – and expensive.
This article identifies what I believe to be the 6 most common psychological traps when investing money or time. If you’ve found yourself adopting this reasoning, the chances are that you’ve fallen under their spell at some point too.
#1: Because you’ve already invested
Do you remember that book you got halfway through, hated, and still finished? Or that awful 3-hour film you endured just because you’d forked out for the cinema ticket?
This is the sunk cost fallacy in action. When we’ve invested money or time, the sense that we’re already committed can encourage us to invest more. This is the case even if the original investment is performing badly.
The concept has close links to what psychologists call loss aversion: the tendency for people to prefer avoiding losses to acquiring equivalent gains. A now seminal study by Amos Tversky and Daniel Kahneman suggested that losses are psychologically twice as powerful as gains.
The effect of loss aversion can be potent in financial investment. We can find ourselves captured by this decision-making flaw. We can throw more money at a lost cause, simply because we can’t stand the feeling of having already invested.
Conversely, we’re much quicker to cash in on profits. We’re brilliant at selling our strong performers too early and doomed performers too late. What’s more, our loss aversion can then extend into influencing our future, wholly unconnected investing decisions.
To alleviate the sunk cost fallacy and loss aversion, we must adopt the bygones principle in making decisions. If you’ve already lost money or time on an investment, let bygones be bygones. Don’t waste any more money or time trying to fix it.
#2: Because everybody else is investing
Human beings gravitate towards trends. Be it the latest in fashion, television, travel, food or money, we almost inexorably follow them. We’re pulled by some force from within, sometimes at a completely subconscious level.
Psychologists call this the herd instinct, and when it comes to our investments, it can be particularly dangerous. Investors can flood similar investments with almost no evidential case aside from the presence of lots of others investing too.
So what’s the driving force? Fear of missing out (or FOMO as some are now calling it) often drives the herd instinct in investing. We feel that if we don’t join the masses in investing, we’ll live to regret it.
Just think of all that potential profit lost! Everyone will be retiring early while I’m still slugging away in the office!
This is precisely the type of thought process that drives the herd instinct. Instead of deciding based on quality information, we make an evidential case based on what ‘everybody else’ is doing. ‘They must be doing something right!’ we convince ourselves.
Frequently we find that hypothesis falls apart. The herd instinct blows up asset bubbles. And then, as night follows day, they burst.
So before you invest money or time, ask yourself this: Are you following the herd? Or have you really – really – done your homework?
#3: Because ‘successful’ people are investing
For every blogger making a living from writing, many try for years but don’t even get close. For every Bitcoin millionaire, many lose a small fortune. For every perfect marriage, many are rocky or even divorce bound.
Success isn’t the only side, but it’s almost always the side that’s brought to our attention. As Rolf Dobelli puts it in his book The Art of Thinking Clearly, “The media is not interested in digging around in the graveyards of the unsuccessful.”
If we do not dig around for those failure stories ourselves, we face a completely asymmetrical view of reality. In psychology, we call this asymmetry in our attention survivorship bias.
Survivorship bias has us looking for the magic success formula only within the success stories. As a consequence, sometimes we try to replicate characteristics that aren’t success factors at all. We assume that copying the model for someone else’s success is a cast-iron guarantee for our own.
You can quickly see how survivorship bias can lead us to invest money and time pursuing ‘fool proof’ success stories. It can be a shuddering blow when we come back down to earth. When we realise there was much more to their success than met the eye, it’s often too late. We’ve already invested so much.
Good investing decisions account for the good, and the ugly.
#4: Because the only way is up!
Do you remember the 2008 financial crisis? You’d be hard pressed to forget it.
But it’s easy to forget that very few saw it coming. When commentators (and movie stars) provide such captivating accounts of what went wrong, you’d think they had it in hand all along.
The truth is different, of course. Markets at this time were in the grip of recency bias. This cognitive bias occurs when we give more weight to recent events and observations than those further in the past.
When it comes to investing cycles, our memories tend to be short. In bull markets, it’s easy to forget about bear markets, and vice versa. Combined with some other psychological biases at play, like the herd instinct, this can create exaggerated movement in financial markets. Markets can ‘over-correct’ in a bear market and become asset bubbles in bull markets.
A concept that can further feed into this thinking pattern is what Daniel Kahneman calls theory-induced blindness. Once you’ve accepted a theory or idea, it’s very difficult to notice its flaws. If we accept that the bull market will continue, we can become locked into the-only-way-is-up mindset, forgetting our not too distant past.
Pay attention to the cyclical nature of returns. Be open to changing your theory. Force yourself to look a little further into the past.
When taking investment decisions with your money or time, it’s unlikely that the only way is up.
#5: Because you only sought out supporting evidence
When we come up with theories, like the only-way-is-up hypothesis, we have an ingenious way of setting them in stone. We source compatible information and filter out contradictory information. This is confirmation bias – and there are no two ways about it: it’s dangerous.
Blind or ignorant to contrary evidence, confirmation bias is everywhere in life. It can guide dangerous political persuasions and ideologies, extend unhealthy personal relationships, feed investor overconfidence, convince us our business ideas are bulletproof.
Inevitably, we cluster with others that hold similar views. We share ideas in communities that reinforce our convictions. Inside the echo chamber, our views reach sky-high levels of credibility.
Confirmation bias can be expensive in all senses. That’s why our approach to investing money or time must take it into account. Being aware that we’re all prone is a start, but we also need to actively seek out and understand views that contradict our own.
As a result, your views may flip, adapt or hold entirely resolute. But one thing is for certain: you’ll invest your money and time better for it.
#6: Because you prefer not to think about it
A few years ago, I had the opportunity to take a closer look at a company’s defined contribution pension scheme. It was a high-profile, international business, packed with smart people – lots of whom had finance backgrounds.
This was the usual type of scheme. You contribute a percentage of your salary and the company contributes a level of matching on top. The total contribution is then invested by the pension provider into equities, money markets, and so on.
Unfortunately, there can be a problem. Companies agree a default pension fund in which to invest the contributions. Sometimes these offer solid returns, but they often offer sub-par growth. This particular scheme was quite defensive, and achieving poor returns during the longest bull market in history.
But here’s the good news. Employees don’t have to be in the default option, and they know that. They can move the contributions to different, better performing funds based on their judgement and risk appetite.
But guess what? Out of hundreds of employees, you could count on one hand those actively managing their pension to achieve better returns.
Hundreds of employees were potentially missing out on thousands upon thousands of dollars – and potentially years of earlier retirement. And why? They simply felt comfortable with the status quo.
Psychologists call this status-quo bias or the default effect. In short, it means we tend to stick to the current state, even if it leaves us at a disadvantage. It’s possible that loss aversion plays a role here. Rather than risk a change, we stick to what we know.
Or more likely in the case of pensions, we’re in a state of investing inertia. We prefer the option of doing nothing. This is one of the key cases from Richard Thaler and Cass Sunstein in Nudge. They suggest that default options could be better leveraged by governments to improve people’s decision making.
We can invest our money and time while actively changing nothing at all. Sometimes that’s an effective investment strategy, but sometimes it’s an expensive one. Either way, we should look up to the horizon and think beyond the default.
How to overcome these cognitive biases in investing
Psychology offers up countless other examples of cognitive biases. But the forms of flawed reasoning mentioned above are perhaps the most significant for investing. They can prove dangerous, and expensive.
It’s therefore crucial that we not only know of them, but we know how to defend ourselves from them.
The next time you make an investing decision, why not set yourself some guidelines?
- Don’t blindly follow the herd.
- Assess each investment on its own merits, not on your past investments.
- Take account of success – and failure – stories.
- Challenge the substance of your theories.
- Seek out and understand views that contradict your own.
- Appraise your options beyond the status quo.
Though it’s easier said than done, awareness and understanding of our cognitive biases is the first stage in resisting them. And when we resist these tendencies, we make much smarter investment choices with both our money and time.