Various authors have written on psychological or behavioral traps that lead people in the wrong direction with their lives in general. Sometimes, these books touch on financial matters, but that is certainly not their main focus. In this article, the intention is to apply some classic forms of dysfunctional psychology directly to the investment arena. We will take a look at some of the most common traps and how to avoid them.
Firstly, there is the so-called anchoring trap, which refers to an over-reliance on what one originally thinks. For instance, if you think of a certain company as successful, you may be too confident that its stocks are a good bet. This preconception may be totally incorrect in the prevailing situation or at some point in the future. For example, the German consumer electronics company Grundig, which was the major European supplier in the 1970s, was wiped out in the 1980s by competition from Japan. Those trapped in the perception that Grundig was there to stay, lost a lot of money.
In order to avoid this trap, you need to remain flexible in your thinking, and open to new sources of information and the reality that any company can be here today and gone tomorrow. Any manager can disappear too, for that matter.
The sunk cost trap is just as dangerous. This is about psychologically (but not in reality) protecting your previous choices or decisions, which is often disastrous for your investments. It is truly hard to take a loss and/or accept that you made the wrong choices or allowed someone else to make them for you. But if your investment is no good, or sinking fast, the sooner you get out of it and into something more promising, the better.
If you clung to stocks that you bought in 1999 at the height of the dot.com boom, you would have had to wait a decade to break even, and that is for non-hi-tech stocks. It's far better not to cling to the sunk cost and to get into other assets classes that are moving up fast. Emotional commitment to bad investments just makes things worse.
Linked to the above is the confirmation trap. People often seek out others who have made, and are still making, the same mistake. Make sure you get objective advice from fresh sources, rather than phoning up the person who gave you the bad advice in the first place. If you find yourself saying something like, "our stocks have dropped by 30%, but it’s surely best just to hang onto them, isn’t it?" - you are seeking confirmation from some other unfortunate in the same situation. You can comfort each other in the short run, but it’s just self-delusion.
Situational blindness can exacerbate the situation. Even people who are not specifically seeking confirmation often just shut out the prevailing market realties in order to do nothing and postpone the evil day when the losses just have to be confronted. If you know deep down that there is a problem with your investments, such as a major scandal at the company or market warnings, but you read everything in the newspaper apart from the financial pages, you are probably suffering from this blinder effect.
The relativity trap is also there waiting to lead you astray. Everyone has a different psychological make-up, combined with a unique set of circumstances extending to work, family, career prospects and likely inheritances. This means that although you need to be aware of what others are doing and saying, their situation and views are not necessarily relevant outside their own context.
Be aware, but beware too! You must invest for yourself and only in your own context. Your friends may have both the money and the risk-friendliness to speculate in pork belly futures (as in the movie "Trading Places"), but if you are a modest earning and nervy person, this is not for you.
For some people, the superiority trap is extremely dangerous. A lot of investors think they know better than the experts or than the market. Just being well educated and/or clever does not mean you don’t need good independent advice and, even more so, it does not mean you can outwit the pros and a complex system of markets. Many investors have lost a fortune through being convinced that they were better than the rest. Furthermore, these people are easy prey for some of the other traps mentioned above.
There are (and have always been) professors of finance at the best universities who really are brilliant technically, and this can delude them into thinking that the pickings are easy out there in the real world. Some really do cut it, but others are in for a rude awakening beyond the ivory tower. Odd as it may sound, someone with a Ph.D. in finance may in fact lead you in the wrong direction (too calculating, too confident), while someone with no more than a high school diploma may have an amazing feel for the market and make a fortune.
The Bottom Line
Human psychology is a dangerous thing, and there are some alarmingly standard mistakes that people make again and again. It is very easy in the heat of the moment, or when subject to stress or temptation, to fall into one of these mind traps. The wrong perceptions, self-delusion, frantically trying to avoid realizing losses, desperately seeking the comfort of other victims, shutting out reality and more can all cost you dearly. Be aware of the nature of these traps and always be honest and realistic with yourself. Furthermore, seek advice from competent and knowledgeable people of integrity who will bring you back to reality before it is too late.