Is your mind keeping you from making sound investment decisions? How you think about investing can have a huge impact on your success!
In this psychology-of-investing post, we're looking at five common mental traps that investors fall into. We'll explain:
- What each trap looks like,
- Why they're a problem, and
- How you can overcome them.
By understanding and sidestepping these psychological pitfalls, you'll be better equipped to make smart, confident investment decisions.
So let's dive in and find out how to keep your mind from messing with your money.
1. The Analysis Paralysis Trap
What it looks like: I don’t want to start investing until I have learned everything about every investment type so I can always optimize my portfolio.
Why it’s a problem: Time spent learning is time not spent in the market, which means missed opportunities. Worse, the longer you wait to start, the less time you have to enjoy the compounding returns that provide exponential growth.
How to overcome it: Take the leap and learn as you go, knowing that you’ll make mistakes along the way. The sooner you start, the sooner you can make your mistakes, learn your lessons, and hone your investment strategies.
2. The Loss Aversion Trap
What it looks like: Sure, I’d be happy to gain $1K from investing, but I’d be devastated to lose even $500. The physiological pain of losing money is way worse than the pleasure of gaining money.
Why it’s a problem: There is no reward without some risk. Low-risk investments, like bonds, CDs, and treasury bills) might not even pay enough to keep up with inflation, meaning your portfolio would lose purchasing power over time anyway. If you invest long enough, you will lose money at some point. But that’s okay because the years with high returns offset the losses from temporary market dips.
How to overcome it: “Set it and forget it.” Commit to a long-term investment strategy and resist the urge to constantly monitor your portfolio’s performance. Instead, check in just once or twice per year to see if adjustments are needed. Make sure your portfolio is diversified across varied investment types. This way, if investment struggles, your portfolio will remain bolstered by the well-performing investments.
3. The Sunk Cost Trap
What it looks like: I have so much money invested in this stock that keeps going down. As soon as the value comes back up to the break-even point, I’m selling!
Why it’s a problem: Continuing to invest in a failing venture because of money already spent can lead to further losses and missed opportunities. In the case of underperforming stocks, you would be better off financially if you sold the stock at a loss and put that money into stocks that are performing well. You can’t recoup the money already spent, but you can decide how to move forward.
How to overcome it: Regularly evaluate investments objectively and be willing to cut losses so you can move that investment capital into a vehicle that is seeing gains.
4. The Pseudo-Certainty Trap
What it looks like: Yikes! My stock portfolio is losing money, and I need to win this money back by any means necessary. Maybe the high-risk cryptocurrency market can help my portfolio bounce back? Let’s try it!
Why it’s a problem: This is a gambler’s mentality. When you’re losing money, you’re so desperate to earn it back that you take unnecessary risks. By all means, cut your losses and move your money into assets that are performing better. But don’t look for a quick fix in high-risk vehicles. You’re statistically more likely to dig yourself into a deeper hole that way.
How to overcome it: Practice patience. You might not be able to recoup losses immediately, but that’s ok because you can recover them over time. Instead of panic-buying into high-risk deals, switch to a proven strategy, like investing in real estate.
5. The Superiority Trap
What it looks like: Not to brag, but I’m smarter than the average person, and I can use my intellect to outperform the market.
Why it’s a problem: Statistically, beating the market as an individual investor is highly unlikely. This is largely because 1) you don’t know what you don’t know and 2) markets are so complex that unforeseen circumstances can pop up out of nowhere. Relying on your own knowledge and experience reduces your chances of capitalizing on opportunities.
How to overcome it: Leverage the knowledge and experience of industry pros. Take real estate for example. Investing in a turn-key property on your own requires you to shoulder the financial burden and market risk alone. You have to know how to find and screen tenants, manage day-to-day operations, avoid legal issues, and increase rental property value over time. Any blind spot can result in losses. By comparison, if you were to invest in a real estate syndication project, you would have a whole team of experts handling every detail of your investment to maximize return potential while minimizing risk.
The Bottom Line
We like to think that we’re all perfectly rational investors, being led by the numbers. But the psychology of investing shows that your subconsciously biased thoughts play a role too.
The good news is that an extra dose of mindfulness goes a long way toward combatting these mental traps. And with the tips listed in this post, you can train your brain to make better financial decisions.