Behavioral psychology in terms of Finance helps us understand our behavioral weaknesses, which could ultimately lead us to better self-awareness as traders and improvement of our investment success. This lesson will focus on different behavioral theories and patterns with a potential detrimental effect on our portfolio alongside some coping strategies against them.
The Dunning Kruger Effect
It has probably occurred to you that suddenly everyone became an “expert” in topics like sports, politics, trading, or how “you have to buy Bitcoin because it is going to hit $1 million very soon.” Some of the people, spreading all this wisdom, look so confident that you almost believe them. But then you start listening more carefully, and you understand that they don’t know even half of what is coming out of their mouths.
This strange phenomenon is called “The Dunning Kruger effect”, and yes, it can affect your trading behavior as well. It explains a person’s inability to recognize their own lack of ability. Without self-awareness, people cannot objectively assess their own competence or incompetence. This is why many traders feel extremely disappointed when they fail to achieve the expected profits because they cannot recognize their own lack of knowledge.
The Fear of Missing Out
Another strange and potentially dangerous behavioral pattern is the fear of missing out or FOMO. It has no technical or fundamental basis, as it entirely comes from the fact that we, as traders, are still human. We are not machines functioning on algorithms. FOMO is a reactive and emotional response. But it’s natural and generally unavoidable unless you are self-aware enough to identify that you are falling for it. If you hear traders complaining about missing the opportunity to buy a rapidly rising stock too often, you probably know what I am talking about.
Let’s talk about stock market bubbles and Herding behavior
The first step in avoiding investment mistakes based on behavioral biases is to be aware of the existence of these biases and to understand how they work. Stock market bubbles are an example of this, as the majority of investors continue to buy even when they know that stocks are significantly overvalued. Not only stocks but any traded good can fall prey to this communally irrational behavior.
Group Dynamics can have significant negative effects on investment returns. Not only can Herding Behavior end in buying high and selling low once the bubble has burst, but Herding Behavior and Groupthink can lead investors to buy assets that are unsuitable for them. For example, many private investors who suffered losses when the technology bubble burst in 2001 did not really have the high-risk tolerance needed to invest a high proportion of their portfolio in such stocks. Furthermore, most did not structure the rest of their portfolios to suitably balance the risk they took in the technology sector.
How to handle Group Dynamics
Only follow an investment fashion if it fits with your existing personal portfolio, your risk tolerance, and your own investment approach. Take advantage of the strengths of group decision-making, such as improved accuracy and a broader range of possible solutions. But be aware of the pitfalls of group influences – these include in-group pressures that can suppress opposing ideas and an illusion of invulnerability within the group.
Selective Perception
Our view on a stock influences how we perceive new information about it. We tend to focus on the information that supports our existing view and to underestimate contrary information. We tend to hold on to a negative view on an investment that led to a loss even if it is highly attractive now.
How to handle the selective perception bias
Use a trading system that relies on numbers generated either from technical or fundamental analysis and act on these signals in a disciplined way. Establish and use strict stop-loss benchmarks.
Pride and regret are human characteristics that explain why decisions we take are not always in our best interests. Another situation in which we tend to harm ourselves is when facing speculative, risky decisions: We discover that when private investors face losses, they are particularly prone to taking on excessive risk.
Peculative Investments
When confronted with losses, many investors respond by taking on much more risk, sometimes with disastrous results. While investors generally try to avoid losses, some level of highly speculative investments is common. Resulting portfolios are considered in different mental accounts with different attitudes towards risk. So, what you want to do is limit the size of these speculative investments. Don’t throw good money after bad and always invest based on a solid investment case.
To sum up
One of the best ways to stop losing and start making consistent profits by trading is to become self-aware and admit your own mistakes to yourself. If whatever you are doing is not working, you simply have to acknowledge that you don’t have all the answers and you need some assistance. In other words, you always have to be open to learning.