Rather than just stashing a few dollars away in a savings account, you’d be better off putting your money into something that can make it work for you. And that’s precisely what investing is all about.
But there’s always some level of risk associated with investing. There are no guarantees that you’ll make a return, nor can you predict exactly how much money you stand to gain with any given investment.
What’s worse, your cognitive biases can lead to certain investment traps and poor investment decisions. It’s important to recognize what these traps are so you can avoid getting caught up in them and ensure that the choices you make about where to park your money are good ones.
New to investing? Check out our beginner’s guide to investing.
Types Of Investing Biases
There are generally two types of biases that can throw a wrench in your investing career: cognitive and emotional. Both biases involve being prone to think and behave a certain way in a specific situation, including investing. It can be easy for investors to find themselves trapped by these biases given the fact that investing typically involves dealing with a wide array of possibilities.
There are several factors that can get in the way of an investor making a good investing decision. Let’s take a closer look at some of the common biases that can be involved in investing.
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Investment Traps To Look Out For
Understanding the different types of psychological traps that can affect your investments profitability is key to making better investment decisions and lowering your risk. By knowing what these traps are, you’ll be able to identify them and make better investment decisions.
Here are some common investing traps to avoid, and the solutions to help you overcome them.
When the idea of losing money overshadows any potential monetary gains that you could potentially make with an investment, loss aversion may be involved. When it comes to investing, loss aversion occurs when a person completely avoids investing in order to avoid suffering any losses in an investment due to unknown risk. There is more concern about avoiding losses than seeking profits.
When it comes to investing, there is always risk involved, though some investments are riskier than others. When loss aversion creeps in, you’ll miss out on any potential to make profits because you’re too worried about losing your investment capital. While taking on too much risk may be problematic, so is not taking enough risk.
Loss Aversion Solution
While a savings account can be a good option for short-term goals, it isn’t the best for long-term savings due to the inflation rate. The interest you build through a savings account is often outpaced by inflation, which is why investing is important. It’s best to come up with a sound investment strategy and not let your emotions affect your decision. Simply allow yourself to and to get a little uncomfortable, as long as you stick to your investment strategy. Make educated decisions about where to invest by choosing assets that have a good track record.
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On the other end of the spectrum from loss aversion is a surplus of confidence. In this case, you may see yourself as better than you actually are.
If you are overconfident with your investments, you may not implement the safeguards needed to protect your investment capital. Instead, you may make poor investment decisions and inadvertently take on too much risk which can lead to significant losses.
If you’re relatively new to the world of investing, consider working with an experienced investment professional who can keep you and your investments in check. These experts can also help you come up with a sound investment strategy that can optimize profits while hedging against risk.
You might also want to consider adopting a more passive investment approach to help keep any poor decision-making out of the process.
Anchoring involves holding on to the idea of the initial value of an asset to the point where it causes a person to make poor decisions going forward. This typically happens when an investor buys a certain stock at a specific price and keeps that price in mind when making subsequent judgments.
As such, the investor may hold onto the stock for far too long because they are anchoring on the higher price than the stock was purchased for, when in reality, the stock probably should have been sold off long ago.
Maybe you bought a stock at $50, for instance, and saw the stock soar to $100 at one point. The stock price then falls again, but you continue to hold onto it in hopes that it will soon reach that $100-mark again.
But perhaps the stock was overpriced at $100 and likely will never reach that height again. As such, you’d be keeping your capital tied up in a stock that you could have been investing in a more lucrative investment.
Try to keep in mind that future investment performances are never guaranteed. Just because a stock performed really strongly at one point in the past doesn’t mean that will happen again. Do some homework on an asset’s price history to help you understand how it will likely perform going forward, and be open to new investment information, even if it may not perfectly reflect what you initially learned about a stock.
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Similar to anchoring, the sunk costs trap causes investors to hold on to a stock that’s fallen in value since it was purchased. These individuals will hold onto the stock hoping the price will return to where it was when it was first purchased to recoup any losses. In this way, the investor is protecting their decision to buy and hold that particular stock, which can have a negative impact on their investment portfolio.
Sunk Costs Solution
Accept the loss or the fact that you made a poor decision. If your investment does not pan out the way you had initially hoped, part with it before the price of the asset sinks even further. Avoid any emotional ties to your investments to help make it easier to unload them before things go from bad to worse.
“Fear of Missing Out” — or FOMO — is a real phenomenon that affects many in the investment world. This is also closely related to herd behaviour bias, as it causes people to follow what others are doing without putting in much original thought.
When it comes to investing, investors with FOMO or herd behaviour bias may follow other investors instead of doing their own due diligence and making their own decisions about where to invest.
Regardless of the risk level or potential for gains, investors who fall under the FOMO trap may make poor investment choices as a result. Further, investors may fear that they’re potentially missing out on a lucrative investment if they see their colleagues pouring their capital into it. Rather than feeling left out, investors caught in this trap feel safer and more comfortable following the herd.
Don’t be too quick to do what other investors are doing without having first done some homework on your own. Assess the investment carefully and review the company’s fundamentals before deciding whether or not it’s a good investment.
Further, ask plenty of questions when a hot stock is being touted as the next big thing. No matter what everyone else is doing, make sure you have a solid investment strategy and stick to it.
It’s easy to develop an emotional attachment to something we own. It happens all the time in the world of real estate: homeowners often place more value on their home than what the property may actually be worth. The same principle applies in the world of investing.
Investors often hang onto an asset for longer than they probably should simply because of an emotional connection that was inadvertently developed. But holding on to something that’s not profitable and may be a detriment to one’s investment portfolio is a bad idea. Instead, the money being held up could be invested elsewhere.
Emotional Attachment Solution
Be mindful of your emotions and don’t allow your feelings to get in the way. Make an effort to be conscious of your feelings towards an asset you own and detach emotionally from it. This will make it much easier to let go of the asset if its value plummets.
Investment Trap FAQs
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Investing already comes with risk, but you may be even more vulnerable if you find yourself caught up in any one of the above-mentioned investing traps. Be aware of what these traps look like so you can spot them before they impact your investment decisions.