Psychology of Investing

As investor, we often underestimate or are unaware of the impact of our emotions on our Investment returns. Yet, we lose more than half of our returns to emotions (source Dalbar).

(Special note: Dalbar then concludes that Market Timing does not work. Actually, it means that investors are bad market timers, not that Market Timing does not work. Investors do not use discipline in timing their entries/exits in the market but get sided by their emotions.).

It is therefore worth spending some time understanding how our emotions affect our investing and what we can do about it.

Many researches have been performed on this subject – called Behavioral Finance – and many Psychological Traits as well as their impacts on Investor’s behavior have been characterized.

Here are some of the main mistakes - called Emotional Biases - that investors make and suggestions to minimize them.

You will substantially improve your returns if you adapt your investing to accommodate these powerful biases.

Overconfidence Go back to Top

Many investors attribute too much of their performances (when they are good) to their own skills rather than luck or simply a bull market. It is great to feel confident but being over-confident in investing usually leads to the following traps:
  • Trading too much and paying too much commissions
  • Taking too much risk: investing in smaller/riskier companies and lacking portfolio diversification

Solutions
  • Use a Stock Basket Account: this will reduce transaction costs coming from possible over-trading. In addition, a stock basket account allows to own a large number of stocks at very low cost: it is then much easier to be well diversified.

  • Do not buy again the same stock within 3-6 months of Selling it: investors tend to keep checking performances of a stock they just sold, even though they don't own it anymore. This often leads them to perform another transaction (buy) on the same stock shortly after selling it.

  • Check how a stock fits in your portfolio before you buy: does it increase or decrease its volatility? Riskgrades can analyze your portfolio risk for free. Select "Portfolio Analysis" then "Portfolio Simulation". To check how your portfolio risk change when you add or remove a stock, perform a "What If" analysis.

Loss Aversion and Fear of Regret Go back to Top

Are you selling your winners too soon and keeping onto your losers too long ? Well, most investors do !
  • When a stock drops, investors do not want to sell because they fear it will go up and they will miss the recovery. They always tell to themselves “I’ll sell when I break even”. Most often, these stocks underperform because it takes time for the market to re-consider them.


  • When a stock rises, investors quickly sell because they fear it will drop so they want to secure the gain. Most often, these stocks further rise because of Momentum and investors do not reap a greater portion of the gain.

On top of holding losing investments, this bias further reduces returns by being Tax inefficient.


Solutions
  • Sell ˝ the position only.
    Loss Aversion is a difficult psychological bias to overcome so instead of trying to completely cut your loss and let your winner ride, doing it half way is a first step.


  • Use Trailing Stop Loss on ˝ of your position. For many gurus, Stop Loss is an important factor to superior Investment returns. BUT, it can be emotionally difficult to use Stop Loss so using it on ˝ of your position is a first step. If you have the discipline to use Stop Loss then, obviously, this does not apply to you.

  • Alternatively, use Trailing Stop Loss on winning positions only. It is easier to sell winners than losers. Possibly use a tight Stop Loss if you want to secure your gain: for instance 5% below current price instead of the usual 10%-20%. In this case, you can participate in any further stock rise but will give up little gain if the stock drops.

  • Think of the Tax you will save when selling losers and letting winners ride: you can create Tax Loss by selling losers and delay Capital Gain Tax by keeping winners.

Mental Accounting Go back to Top

Investors have great difficulty to see their portfolio as a whole. Instead, they see each investment separately and take decision individually rather than collectively. Investors get emotionally attached to each investment they choose.

This can lead to unnecessary emotional pain when few of your investments are down but your overall portfolio is up. You should see the portfolio as a whole rather than focusing on each issue.

Mental Accounting feeds the Loss Aversion / fear of regret effect. By seeing each of your investment individually, you’ll notice the rise and drop of each stock more easily and will more likely sell winners too soon and hold onto losers too long.

This bias can be greatly reduced by using Mutual Funds (or best an Index Funds or ETFs as Mutual Funds are too expensive). The following applies mainly if you buy your own stocks.


Solutions
  • Use Mechanical Stock Picking: with Mechanical Stock Picking, you buy and sell all your stocks together rather than building your portfolio stock by stock. It is easier to see your Stocks Portfolio as a whole. In addition, with mechanical stock picking, you don't spend much time selecting each stock which help remove any emotional bond with the stocks you're buying.


  • Consider Foliofn as your Broker: Foliofn has a nice feature called "One Click Diversification". In one click, you can sell all your Stocks, buy a complete new portfolio or rebalance your entire portfolio without having to compute how much to buy or sell in each position. This makes it easy to see your entire portfolio as a whole.

    This feature is extremely well adapted to Mechanical Stock Picking where you buy or sell all your stocks at the same time. It basically helps you consider your stocks portfolio as a Mutual Fund.

Herd Mentality Go back to Top

Investors tend to follow the crowd. This is further aggravated with the media that comment (or rather "over-comment") every single change in the economy, geopolitics or simply the weather. Investors pay too much attention to events happening in the short term, often extrapolating the short term too far in the future.


Solutions
  • Control your Investing Environment: the best way not to be influenced by the herd is to avoid exposure to the herd (especially the media). Avoid watching CNBC every day or reading investment newspapers and magazines too often. Try not to log onto your online broker every day or so: once a month/quarter is far enough. Do not discuss your stock picks with your friends, colleagues, family...

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