The relationship of people with the world is different in each case. In general, however, there are certain patterns, relationships, biases, and behaviors that are similar. That relationship between human nature and investments is really very close. Money may not have feelings about people, but people do have feelings about money. A totally irrational relationship, but one that logically happens. Hence the importance of understanding the psychology when investing.
We act unconsciously most of the time, about 95% of it. Abstracting yourself and seeing events with the proper perspective is essential in making decisions. And when it comes to how much capital you can have in your portfolio, the last thing to do is make non-rational decisions. However, we are human, and we cannot be rational 100% of the time. For that reason, I am going to talk about certain patterns that develop in a generalized way. What will lead you to detect when factors are influencing your decisions, which should not be there.
The confirmation bias in investing
Confirmation bias is the tendency of people to give priority to that information that favors or affirms their theories and hypotheses about something. Examples:
- A person believes that the Earth is flat. Look for information that supports their way of thinking. Find the information, and think "AHA! I knew it! The Earth is flat! ».
- A person believes that there is a conspiracy about something. He looks for information that validates his theories and he finds it. Think again ... How smart I am! He was right!".
There are two types of reasoning, deductive and inductive. The deductive focuses on premises to reach a conclusion, and the inductive on seeking premises that validate a conclusion. The confirmation bias then, is a systemic error about inductive reasoning. A general trend that in the end, to a lesser or greater degree, all of us show.
Es highly dangerous and destructive, and this is why I put it in the first place. It directly affects more than you can think of in our life, and of course financially. It is a proven fact that many investors tend to believe that an investment they have chosen may be good, but feel insecure (fearful). From there, looking for information to support your theories is a mistake. An investor who indulges in this type of behavior should stop and not invest. Unless, your conclusions are strong enough not to depend on the opinion or assessment of others.
Failure to act accordingly can make rash and overconfident decisions and overpaying something that is not worth it. You will observe this behavior in the economic bubbles.
How to defend against confirmation bias?
In the event that an investor begins to develop this bias, there are techniques to stop it. One of them is about imagine the position of someone who would not invest in the chosen company. From there, give arguments that deny that it is a good investment. Have a kind of "discussion."
Another technique is imagine that all or a large part of the investment has been lost, and ask yourself why that might happen.
Investors who base their decisions without allowing themselves to fall into the confirmation bias reap higher returns.
Search for patterns (pareidolia in finance)
Second, and also very destructive. One of the ways your brain can trick you is by its configuration. We are programmed to look for analogies, similarities and patterns Everywhere. It is like a software that comes installed in you, you are not going to get rid of it. Having no notion of this phenomenon it will lead you to believe the possible "fallacies" that your brain has constructed, but they are actually an illusion.
- This is not an intelligence problem. In fact, it is the basis of how we know the world, we make sense of words, we understand the environment, and we anticipate that something may happen.
- Superstitions. Just because something has happened many times does not mean it will happen again. As long as the reasons are solid.
If you are a logical, mathematical and therefore analytical person, I am sure that you will inadvertently see patterns in many quotes. This skill is incredible, it is also done constantly and compulsively. But just as there are clouds that look expensive and are not, you must learn that things happen without connections to each other.
Drag effect, investing psychology
Known as the Bandwagon effect, jumping on the bandwagon. It is generated by the opportunism of seeing how other people believe in something and want to imitate. Often because things are going well (or so it seems). And what it usually causes is that the demand for a product or action increases, for example. As demand increases, the price tends to rise, and if many people make a profit, others begin to be interested in order not to lose the opportunity, raising the demand even more and therefore the price.
It is the main of the effects that propitiate bubbles in finance. It tends to catch a lot of people, even some with good skills and psychology when investing. And the best way to defend yourself is to watch everyone do the same thing, stop to think, and ask yourself "What am I wrong?" Avoiding entering these spirals of collective euphoria will almost always protect you from the greater capital losses that can be incurred.
Drag effect example for an action
Currently we can find shares of companies that are listed on the stock market, whose numbers give us very high valuation multiples for their net profits. Yes, to a large extent they are those investment philosophy companies "growth". However, not all of them will always meet your expectations, and sometimes there are ratings that can be very high. So much so that on paper a bit picturesque scenarios sometimes occur. Let's imagine an example that can be a real case.
Imagine that you meet your neighbor. And he explains that he has a company whose net worth is $ 50.700, and that he has a debt of $ 105.300 and that he is thinking of selling it. That is if you could sell all your own funds more or less you could pay half of what you owe. You ask… "Hey, how much did you earn last year?" And he answers that he won $ 12.000. As you are a very smart person, you take to looking at the results of previous years. And you see that your debt increases faster than you earn.
Given the current circumstances, you ask him how much he sells it for, and he answers that for $ 1.640.000 a company that gives $ 12.000 a year with a debt that does not stop growing. What would you answer? "Oh yeah, $ 1.640.000 seems like a fair price to me!" or rather you would stay thinking ... "This can not be possible".
Sometimes we can fall into the attempt and see assets that do not stop rising in price to benefit from that success. The problem would be to forget that in the end the shares represent portions of real companies and that this valuation may not be very logical. Not always everything has its fair price, since the model or growth expectations can help to make the valuation more or less high. Keeping a cool psychology when investing will help us stay away from bubbles.
Debts Vs Expectations
Do you know of someone who accumulates more and more debts? That goes into that loop from which it does not come out. Do you know if you have savings and want to invest them, what do you expect to gain? Well, this case is simple to understand, but for some reason, I have observed this behavior in a very generalized way.
There are people who either by having loans for the company, mortgages, or any debt with cards, etc., pay interest of the order of 6-7% or even more. Really monstrous percentages. The problem is that if you save something, what use is it intended to give that money. The paradox is when a person decides that the most successful thing is to invest in the stock market or to buy products that give an interest of 2% (for example). If you have a good psychology when investing, and we do not fall into the illusion of money, we will see that this decision is wrong.
Examples of illusion misuse of money
Let's look at things in perspective:
- Debt of 7% or more is incurred. And you have liquidity ("surplus") of which you want to earn 2%. Suppose further, that your savings are equal to your debt ...
If I said "I have contracted a credit of € 20.000 at 7%, and with those € 20.000 I am going to buy a product that guarantees me 2% per year" ... Anyone in their right mind would think either that I am lying or that I do not have no idea what I'm saying.
Well, I say this focused on those people who, because they have a large debt, believe that the smartest thing is not to get rid of it and buy other products. It may be that the person, as a philosophy of life, is not interested in reducing their debt and living day to day. Perfectly respectable. But saving, maintaining a debt, and acquiring returns lower than the interest that is being paid ... No. It simply has no logical foundation.
I hope that these lessons have served you, and that your financial and life decisions will be more correct from now on. Knowing our mental traps and how your psychology works when investing, will end up helping you make better decisions, and not make so many mistakes.