There is a tremendous correlation between our psychological status and our feelings and behaviors about investing our money. More than knowledge of finance, it is the ability to control our temperament that is most responsible for investment success.
A Problem of Extremes
The tendency of all of us to vacillate between extremes of emotion creates a lot of difficulty for us in terms of making good investment decisions. When things are going well, we can experience a euphoria that is completely removed from the temporary nature of our gains. We react to that euphoria by buying when we should not be buying. I buy stocks in several companies. The market, and my stocks, are going up. I congratulate myself on being a savvy stock picker. I get greedy thinking about how much more I could have made. I chase my gains with more money as the market goes up. I end up buying at high prices. When prices go down some, I become fearful and sell. The result: because of my emotions I have bought high and sold low. I curse the stock market and move on.
I want to spend some time discussing some particular psychological pitfalls that can negatively impact your investment performance. By understanding how these behaviors can affect us, and learning how to recognize them, we can improve our chances of being successful investors.
We tend to think we’re smarter than we really are. That’s why most people rate themselves as far above average in many areas, although obviously only a fairly small percentage of people are significantly above average. It is this overconfidence that leads us to believe there is some chance that we will identify the next Netflix before others do, when there is absolutely no reason to think we can.
There are several possible downsides to this overconfidence. One is that we are likely to put too many of our investment dollars into our best ideas. This keeps us from being properly diversified, which increases our risk. Another problem related to overconfidence is excessive trading. The costs of trading, even with a discount broker, are not insignificant. Trading costs can easily add up to thousands of dollars a year if you trade frequently. Multiply that by a multiple years, and you are losing not only dollars but the compounded interest that you would have earned on those dollars.
Another phenomena related to overconfidence is the illusion of control. When an investor has early success, they tend to attribute that to their own abilities, when in fact it may well be random, or the result of the general direction of the market. This misplaced confidence can lead to decisions that don’t take into account the downward movements of the markets.
Solutions to Overconfident Investing
Some people say that using index funds is the only way to make sure you don’t make mistakes in investing. While this automated way does work to some extent, I believe it is possible to take some of your available investment dollars and invest in individual stocks with good results. For that program to work, you need to be aware of, and in control of, the potentially disruptive effects of our natural temperaments.