Feeling nervous about the trade tensions between the US and China?
The upcoming Brexit negotiations? Closer to home, maybe you have
an upcoming speech planned where you have to speak publicly in
front of thousands of people? You are not alone.
Events around us often shape our emotions. Investing is just one prime example. Since many people invest to either preserve or increase their wealth, stakes can be high and emotions can run even higher. A lot can happen when our emotions take hold but here are three fairly common examples.
1. Stronger feelings about a loss than a gain
“Losses loom larger than gains” – Kahneman & Tversky, 1979 on
the loss-aversion theory
Imagine this: if I told you that you had won US$1,000 bucks in a game of blackjack, I imagine you would be happy at this windfall. But let’s say for instance, if you had instead lost US$1,000, would the disappointment you feel be comparable to that initial joy?
Psychologists Amos Tversky and Daniel Kahneman, who first identified the disparity way back in 1979, think that people may feel differently towards wins and losses. This is called loss aversion and is actually very prevalent in individuals who invest.
For instance, you may feel more strongly about negative events such as receiving criticism versus positive emotions you would get from, say, receiving praise. Likewise, consumers have been found to be more responsive to price increases as compared to price decreases.
They would change their habits more if the price were to increase than if the converse happened. So, the next time you register something as a win or a loss, think carefully about what sinks in first.
Let it go – the sunk cost trap
Have you ever bought a purchase only to experience buyer’s remorse? When that happens, do you go “oh no, I MUST recoup my losses!” (i.e. get more use out of it), or do you just accept that “hey, this is a decision that does not matter anymore”? Now if you thought the former, keep an eye out for the sunk cost trap.
The sunk cost trap means that instead of focusing of the future, you look backwards to what you have paid instead. That could vary from not bearing to throw away that ugly dress you bought (an eternity ago) for a high price, to not being willing to let go of a bad investment.
It is always commendable to remain committed to a decision but knowing when it’s time to let go is also part and parcel of good decision-making. And this extends to investing too.
2. Attachment to one source: the anchoring trap
Life is full of tough decisions. It would be great to rely on just
one single piece of information instead of being swamped by all
sorts of inputs in an overload. Well…maybe not if it ties you down
in the anchoring trap. As the name would suggest, anchoring ties
you to one piece of information.
How does this work? Remember the adage “first impressions last”? Well for many people, that one impression certainly turns out to be far stickier than expected.
Extend this to volatile markets though, and this same conviction to a sole piece of information might just be too big a risk when your investing decisions rest entirely upon it. So, talk to more people, read up more, and research but be careful not to latch on to just one thing.
3. Being overconfident
Pride comes before a fall – avoiding overconfidence
“Pride comes before a fall” is a proverb that I have heard since I was a young child. Continuous wins can elicit euphoria, with an accompanying surge in confidence levels. But is this overconfidence something to look out for instead?
In history, we have seen this kind of irrational behaviour when prices are trending upwards. In the third edition of “Irrational Exuberance”, a book written by Nobel Prize-winning economist Robert J. Shiller, topics covered include how investors have overvalued the market in various instances; leading to crises such as the dot-com bubble back in 2000, and the housing bubble of 2008.
These two instances have one point in common; investors had huge faith in the markets and invested heavily without noticing that the fundamentals no longer supported the price rises. Consequently, this led to a market crisis. History is one of the best teachers, and this is definitely a particularly painful lesson we can derive insights from.
How can we avoid these pitfalls though? The key is to manage your
perspectives. If you make a mistake, try to slow down and see
whether you have inadvertently fallen into any of these traps, so
that you can refine your strategy over time.
Personally, I also find it helpful to read up on the experiences of people before me. After all, as Isaac Newton once remarked, “If I have seen further, it’s only by standing on the shoulders of giants”.
by Hui Yi Tee, English Writer @ FIGS
19 Oct 2018
(Please note that all views expressed in this article are solely my own and do not represent the opinions of FIGS or its related companies)
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