The 2 big traps of investing behaviour

Humans are fickle and unpredictable. We need to look at the two biggest behavioural finance traps that I believe you can fall into, if you’re not careful, as an investor: hype and confirmation bias. 

If there is one thing I want you to take away about developing the mindset of an investor, it’s that you are your life and you need to control what you can control, and let the investing happen in the background.

The best-performing company in the world does not care about you. It does not know you’re a shareholder, and you need to know that. Focus on what you can control, and let your investing do the rest.

First and foremost within your control is your investing behaviour and ability to avoid the following two behavioural traps:

Hype 

The rise and fall of the value of Bitcoin (or any cryptocurrency) is strongly correlated with the amount of hype associated with the asset, either online or in real life. The more people were talking about Bitcoin, the higher the price became. When a tipping point came and some of the hype wore off, fewer people were suddenly wanting to buy Bitcoin. With fewer people wanting to buy and the same supply in the market, the price fell.

We have seen these cycles come and go over the years with Bitcoin. The reason it’s a good illustration of hype is that it has arguably no intrinsic value. It’s worth what someone is prepared to pay for it.

Hype and FOMO can make us do dumb things. With behavioural finance, this is what’s known as ‘herding’ or a herding bias or mentality – meaning people follow what others are doing without thinking about their own situation and analysis or conducting their own due diligence. I believe herding when investing comes from either or all of the following:

• Being lazy and thinking because others are doing it, it must be okay.
• A deep sense of FOMO on massive returns.
• Not having your own strategy in place and sticking to it.

It’s funny that people will not ‘herd’ to a broad-based index of the top 200 companies in Australia. It only really occurs when there is the chance to strike gold and make lots of money fast. For every cryptocurrency or unicorn company that has gone to the moon, there are thousands of investments that have had hype and investors ended up without a cent.

Just think, if you did put $500 into Bitcoin and it went to the moon and you gained 300 per cent in 2 months, you’d end up with an extra $1500. While this is nice and you’d take it, it won’t change your life. You’ve had a dopamine hit. For it to really change your life, you’d want to have put all of your money in it, and that’s just not wise at all.

To protect yourself against herding behaviour:

• know that if everyone is talking about it, it’s probably too late to invest in it successfully.
• be confident that your strategy works for you and that it’s a long-term play.
• try to remove yourself from manually investing month-on-month – use automation instead.
• understand some big wins on small amounts will not change your life.
• know that it’s real and irrational.

I used Bitcoin as an example, but the truth is it can happen with listed companies too. When the dot-com bubble was expanding, people were buying shares in companies that had no value, no income and no real plan. The values just kept increasing because the demand was increasing. Some of these businesses succeeded, some did not. Some investors lucked out.

Don’t be fooled into thinking because this was a quarter of a century ago that it won’t happen again. Time changes but human nature does not.

Confirmation bias 

When someone asks you which dentist they should go to (or about any other service), you say, ‘You gotta see Lacey! She is the best dentist ever! OMG!’ The thing is, you’ve had a good experience with her, she has looked after you and is reasonably priced. Does that mean she is actually the best dentist? No. How can you know with certainty? You only think she is the best because you have a bias towards this particular dentist because of your familiarity and your own positive experience.

The same can happen with investing. For example, you bank with a big four bank and you figure you may as well own some of its shares because it has been a good bank for you. Or you shop at a large supermarket and figure you should buy shares in it because you’re a loyal customer and you shop there. The thing is, you can’t base your investing decisions and strategy on feelings or irrational biases. These need to be separate – always.

What if the bank you use has the best app and you love using it, but the bank you have chosen to invest in has been a dog for many years and if only you’d chosen another bank, you would have gotten a higher return.

How do I remove confirmation bias? I do this by only investing in broad-based indexes. I also understand that I can’t possibly know everything, and I’m okay with that.

Written by Glen James.

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