Risk particularly in finance and investment is often framed in cold and calculating terms, but such an approach can lead us to neglect its very human features.
More often than simply "an absence of certainty" risk is about our inability to deal with probabilities ( of gain and loss as markets go up and down) in a consistent and coherent fashion.
This causes discomfort.
How we experience and perceive risk is uniquely personal but at the same time certain trends are obvious.
4 common biases tend to exist among investors
- Overconfidence
- Reducing Regret
- Limited Attention Span;
- Chasing Trends
Many authors have written on psychological or behavioral traps that lead people in the wrong direction with their lives in general.
Quite frequently, some classic forms of dysfunctional psychology are directly evident in investing behavior.
#1. Anchoring Trap
This refers to an over-reliance on what one originally thinks.
Imagine betting on a boxing match and choosing the fighter purely by who has thrown the most punches in their last five fights. You may come out all right by picking the statistically more-active fighter, but the fighter with the least punches may have won five bouts by first-round knockouts. Clearly, any metric can become meaningless when it is taken out of context.
In order to avoid this trap, you need to remain flexible in your thinking and open to new sources of information, while understanding the reality that any company can be here today and gone tomorrow. Any manager can disappear too, for that matter.
#2. Sunk Cost Trap
The sunk cost trap is just as dangerous. This is about psychologically (but not in reality) protecting your previous choices or decisions — which is often disastrous for your investments. It is truly hard to take a loss and/or accept that you made the wrong choices or allowed someone else to make them for you. But if your investment is no good, or sinking fast, the sooner you get out of it and into something more promising, the better.
#3. Confirmation Trap
Similarly, in the confirmation trap, people often seek out others who have made and are still making, the same mistake. If you find yourself saying something like, "Our stocks have dropped by 30 percent, but it’s surely best just to hang onto them, isn’t it?" then you are seeking confirmation from some other unfortunate investor in the same situation. You can comfort each other in the short run, but it’s just self-delusion.
#4. Blindness Trap
Situational blindness can exacerbate the situation. Even people who are not specifically seeking confirmation often just shut out the prevailing market realities in order to do nothing and postpone the evil day when the losses just have to be confronted.
The relativity trap is also there waiting to lead you astray. Everyone has a different psychological make-up, combined with a unique set of circumstances extending to work, family, career prospects and likely inheritances. This means that although you need to be aware of what others are doing and saying, their situation and views are not necessarily relevant outside their own context.
Be aware, but beware too! You must invest for yourself and only in your own context. Your friends may have both the money and the risk-friendliness to speculate in pork belly futures (as in the movie "Trading Places"), but if you are a modest earning and nervy person, this is not for you.
#6. Irrational Exuberance Trap
When investors start believing that the past equals the future, they are acting as if there is no uncertainty in the market. Unfortunately, uncertainty never vanishes.
There will always be ups and downs, overheated stocks, bubbles, mini-bubbles, industry-wide losses, panic selling in Asia and other unexpected events in the market. Believing that the past predicts the future is a sign of overconfidence. The investors who get hit the hardest — the ones who are still all-in just before the correction — are the overconfident ones who are sure that the bull run will last forever. Trusting that a bull won't turn on you is a sure way to get yourself gored.
#7. Pseudo-Certainty Trap
This phrase is an observation of investors' perceptions of risk. Investors will limit their risk exposure if they think their portfolio/investing returns will be positive – essentially protecting the lead – but they will seek more and more risk if it looks like they are heading for a loss.
Basically, investors avoid risk when their portfolios are performing well and could bear more, and they seek risk when their portfolios are floundering and don't need more exposure to possible losses. This is largely due to the mentality of winning it all back. Investors are willing to raise the stakes to "reclaim" capital, but not to create more capital. How long would a race car driver survive if he only used his brakes when he had the lead?
#8. Superiority Trap
For some people, the superiority trap is extremely dangerous. A lot of investors think they know better than the experts or even the market. Just being well-educated and/or clever does not mean you wouldn't benefit from good, independent advice. Also, it doesn't mean you can outwit the pros and a complex system of markets either. Many investors have lost fortunes by being convinced that they were better than the rest. Furthermore, these people are easy prey for some of the other traps mentioned above.
The Bottom Line
Human psychology is a dangerous thing, and there are some alarmingly standard mistakes that people make again and again. It is very easy in the heat of the moment, or when subject to stress or temptation, to fall into one of these mind traps. The wrong perceptions, self-delusion, frantically trying to avoid realizing losses, desperately seeking the comfort of other victims, shutting out reality and more can all cost you dearly.
Be aware of the nature of these traps and always be honest and realistic with yourself. Furthermore, seek advice from competent and knowledgeable people of integrity who will bring you back to reality before it is too late.
