Overconfidence in investing leads to poor decisions, while herd behavior prompts following the crowd. Overreacting to losses increases risk, and focusing on short-term gains can neglect long-term goals. Recognizing these tendencies is crucial for better choices.
Overconfidence Effect
The brain tends to make larger decisions when in a state of high confidence. The overconfidence effect causes investors to overestimate their analytical or predictive abilities. For example, an investor who experiences short-term success in the stock market is likely to believe that they will always make accurate judgments, leading them to take high-risk investments.
In a real-life case, one investor, after achieving high returns on initial investments, invested all their assets in a leveraged fund promising high returns. However, as market volatility increased, their predictions went awry, and they lost most of their principal. To prevent this, it is essential to recognize one’s limitations, consider market uncertainties, and systematically review all investment decisions.
Herd Behavior and Conformity Effect
The brain places a high value on social connections and has a strong tendency to conform to group psychology. Many investors behave according to herd mentality in investment environments. For instance, when a particular stock gains popularity, many people tend to buy it without in-depth analysis.
One investor saw a technology stock rapidly rising on social media and purchased it, but ultimately incurred significant losses due to the overvalued price. To overcome herd mentality, it is crucial to make independent decisions based on personal analysis and not get swept away by the actions of the crowd.
Overreaction to Losses
When losses occur, the brain experiences stress and may exhibit an overreaction in an attempt to recover. This can lead to riskier investment behavior. For example, after incurring a significant loss, some individuals may invest additional funds into high-risk ventures to recoup their losses.
One investor, after suffering substantial losses in options trading, reinvested using higher leverage but ultimately faced even greater losses. To avoid such behavior, it is important to calm emotions after a loss and make planned decisions based on analysis.
Distortion of Success Experiences
The brain tends to exaggerate past successes while downplaying failures. This can lead investors to only remember their successful cases, resulting in unrealistic expectations based on those experiences.
For instance, an investor who had previously succeeded in a particular industry might reinvest in a similar industry, only to face unexpected losses due to changing market conditions. To avoid distorting success experiences, one should make cool-headed judgments based on data and analyze market changes.
Temporal Distortion
The brain often prefers short-term satisfaction over long-term rewards. This can lead to mistakes where long-term investment goals are overlooked in favor of focusing on short-term gains.
One investor planned for long-term investments for retirement but, in pursuit of short-term high returns, lost a significant portion of their assets during a market downturn. To prevent temporal distortion, it is necessary to remind oneself of long-term goals and diligently follow a plan to achieve them.
Rationalization
The brain has a natural tendency to justify even poor decisions to maintain psychological comfort. When investors make a bad investment, they may come up with reasons to hold onto it rather than acknowledging their mistake and cutting losses.
For instance, an investor who purchased a failing stock might convince themselves that the company will turn around, despite all evidence suggesting otherwise. This can lead to deeper losses.
To combat rationalization, adopt a disciplined approach to investing, where decisions are based on data rather than emotions or personal justifications.
Familiarity Bias
People tend to invest in companies and industries they know well, often at the expense of diversification. While familiarity can be comforting, it can also lead to an overconcentration of risk.
For example, an investor working in the tech industry may put all their money into tech stocks, ignoring opportunities in other sectors. If the tech sector crashes, their entire portfolio could suffer.
To avoid this, ensure a well-balanced portfolio across different industries and geographies.
Brain Energy Consumption
Making complex investment decisions requires significant mental energy, leading to fatigue and poor judgment over time.
For example, a trader who constantly monitors the market and makes frequent trades may experience decision fatigue, increasing the likelihood of making errors.
To counteract this, automate parts of your investment strategy and take breaks to maintain mental clarity.
Stress and Decision-Making
High stress impairs the brain’s ability to make sound investment decisions. When under stress, people tend to make impulsive or overly conservative choices.
During a market crash, for example, some investors panic-sell out of fear, only to regret it later when the market recovers.
Managing stress through structured investing plans and mindfulness techniques can improve decision-making.
Learning from Experience
While experience can be a great teacher, our memory is often biased. Investors may remember past successes vividly while downplaying failures, leading to overconfidence.
For instance, an investor who profited from a few trades might think they have a superior strategy, ignoring past losses.
Keeping a trading journal and reviewing both successes and failures objectively can help mitigate this bias.