Psychological quirks that destroy investment returns

Tim Richards has written a book – The Zeitgeist Investor – which is all about what happens when our brains and the stock market collide. He has written an article about our psychological quirks that destroy investment returns.  Making money from stocks is easy enough if we can defeat the main enemy – ourselves. The first line of defense against this is to recognize the problem. Here are seven psychological quirks to look out for.

1.     Overconfidence and optimism: Most of us are way too confident about our ability to foresee the future, and overwhelmingly too optimistic in our forecasts. This finding holds across all disciplines, for both professionals and non-professionals, with the exceptions of weather forecasters and horse handicappers. Lesson: Learn not to trust your gut.

2.     Hindsight: We consistently exaggerate our prior beliefs about events. Market forecasters spend a lot of time telling us why the market behaved the way it did. They’re great at telling us we need an umbrella after it starts raining as well, but it doesn’t improve our returns. We’re all useless at remembering what we used to believe. Lesson: Keep a diary, revisit your thinking constantly.

3.     Loss aversion: We hurt more when we sell at a loss than we feel happy when we sell for the same profit. But stocks don’t have memories – decisions on whether to buy or sell should always be independent of your buying price. Lesson: Ignore buying prices when deciding whether to sell.

4.     Regret:  Investment decisions should overwhelmingly be about risk, and risk implies a judgement, which may turn out to be wrong, often through bad luck rather than bad thinking. Becoming overly focused on past decisions that have gone wrong without analyzing whether the decision made was rational under the circumstances isn’t rational. Investing involves making mistakes and is often down to luck. Lesson: Learn to live with mistakes.

5.     Anchoring: Ten years or more of research has shown we have a nasty tendency to ‘anchor’ on specific numbers. Psychologists can change the results of simple estimation questions simply by posing an earlier unrelated question containing a number. Lesson: Don’t get fixated on specific numbers, such as buy prices, stop loss prices, or index values.

6.     Recency Bias: We pay more attention to short-term events than the longer-term. So the effect of a short-term downturn in a company’s fortunes may be exaggerated, or we may simply assume that current market conditions will persist forever. Lesson: Buy some history books, and look beyond the short term.

7.     Confirmation Bias: We just love other people to confirm our decisions. And other people just love us confirming their opinions. In fact we could just get together and have a regular love-in but it doesn’t make for good investing. The only money you lose is your own. Lesson: Make your own decisions; don’t worry about what others think.

Richards’ all-time favourite is Myopic Loss Aversion. This is where investors can’t stand the sight of red ink in their portfolio – they avoid short-term losses at the expense of long term gains. Richards suggests that such people should be physically restrained from buying shares. Let them play checkers with five-year olds or something they can always win at.