It is very easy for Investors to be their own worst enemies. Deciding to actively manage your own portfolios have, on average, lagged behind the S&P 500’s returns by one to two percent every year over the last 20 years. Humans are emotional by nation which leads to buying and selling at the worst possible times. Sometimes we hinder our own progress, but we can learn to make better financial decisions. It is not easy, but it is possible with discipline and practice you can change these habits. Below we will go over some ways to integrate psychology for investing into our investment strategies.
One important lesson about Psychology for Investing
When people learn about behavioral psychology, they often identify the mental mistakes made by others. However, it is important to recognize the same mistakes in yourself as well, and often these go unnoticed. We all seem to have a blind spot when it comes to recognizing these traits in ourselves.
Why do humans suffer from behavioral biases? The answer lies in the fact that our brains have been refined by the process of evolution, just like any other feature of our existence. But remember that although we are well designed for the environment that we faced 10,000 years ago, we may be very poorly equipped to deal with today’s information age environment.
Why do we need to Pre-commit to a strategy?
Research shows that we are all bad at predicting our future behavior in the heat of the moment. This is called an empathy gap. Empathy gaps are natural. For example, a good example is when you’ve just eaten a large meal, you can’t imagine ever being hungry again. Similarly, it’s unwise to go shopping for food while hungry as you will almost always overbuy.
In order to prevent yourself from falling into emotional empathy gap pitfalls, it is important to prepare and pre-commit. Investors should learn to follow the seven P’s which are: Perfect planning and preparation prevent piss poor performance. We should always do our investment research when we are in a cold, rational state and when nothing much is happening in the markets. This will make us more likely to follow our own analysis and strategy, which should be outlined in a list of prepared action steps.
Always ask yourself why you own a Investment
I want you to go ahead and answer some questions:
- Do you believe that you are above average at driving cars?
- Do you believe that you are above average at your job?
Most people tend to answer each of these questions in the affirmative. Optimism is often ingrained in the human psyche, and this tendency is amplified by the illusion of control. We often think that we have the power and influence to produce a particular outcome.
When considering the sources of optimism, they have been broadly categorized as either environmental or genetic in origin. Many of our cognitive biases presumably had some sort of evolutionary advantage. What possible role could optimism have played in our evolution as a species?
Some evolutionary psychologists have suggested that humans are prone to abandon tasks associated with negative consequences, so it was biologically adaptive for humans to develop a sense of optimism. It has also been argued that when we are injured, our bodies release endorphins. Endorphins generally have two properties: they have the analgesic property of reducing pain and they produce feelings of euphoria.
Optimism may also convey benefits beyond the personal. Psychologists have found that optimists tend to cope much better and live longer than pessimists do when faced with dire news about illness or other problems. So, you could argue that optimism is a good life strategy, but it isn’t necessarily a good investment strategy.
How do you prepare for investment decisions?
The saying “Those who predict don’t have knowledge” is often attributed to the Chinese philosopher Lao-tzu, yet we are seeing that most of the investment industry seems to be obsessed with trying to guess the future. This may stem from the way many investors are taught to think about investing.
With discounted cash flow valuation, investors forecast cash flows for the company into the future. However, as psychologists have shown, people tend to have an overconfidence in their own abilities and thus are likely to overestimate the accuracy of their predictions. A study has shown that analysts’ accuracy in forecasting a company’s stock price performance is no better than chance. When we look at the five-year growth rate forecasts from analysts versus the actual outcomes, a rather depressing reality asserts itself. The stocks that analysts expect to grow the fastest actually grow no faster than the ones they expect to grow the slowest.
If forecasting investment performance is so inconsistent, then the natural question becomes: why do people keep producing them? The answer is that the demand for such information produces the supply. So if some investors want meaningless information then someone will provide it to them. You have to wonder though if all these experts get bored with being utterly wrong and would like to give up guessing the future.
A study of a small group of investment analysts revealed that when they were asked to reassess how well they understood the underlying process and forces at work that impacted their investment decisions, the experts showed no sign of cutting their faith in their own understanding of the situation. Even when presented with incontrovertible evidence that they were wrong. Instead, the study uncovered five frequently used excuses for their bad forecasting.
- The “Single Prediction” Defense – You can’t evaluate my forecasting skills based on a single prediction.
- The “If only” Defense – If only the Federal Reserve had raised rates, then their prediction would have been correct. Experts claim that they would have been correct if only their advice had been followed.
- The “I was almost right” Defense – Although the prediction’s outcome did not occur, it came close to happening.
- The “ceteris paribus” Defense – Something unexpected happened, which invalidated the forecast; therefore it wasn’t my fault.
- The “It Just Hasn’t Happened Yet” Defense – I stand by my prediction. The event I predicted hasn’t occurred yet, but that doesn’t mean it won’t.
These excuses allow failed forecasters to avoid acknowledging their poor forecasting abilities. You should be careful not to use these excuses yourself when justifying your own forecasts. So the next time you hear an “expert” make an excuse for why they didn’t predict what actually happened, listen closely to see which of these paltry defenses they deploy.
