Are you falling into the psychological traps that many private investors tend to?
I've recently been reading "Reminiscences of a Stock Operator" -- a disguised biography of legendary trader Jesse Livermore.
Now Livermore was an out and out trader who made and lost a fortune many times over and ended up penniless and committing suicide. His style goes against the grain for many Fools, myself included, who advocate a long-term investing approach as opposed to the gut instinct trades of Livermore.
But the man was certainly a rare type of genius and there's much we can learn. On the surface, his style was counter-intuitive advocating that traders should let their winners run and cut their losses quickly. But he also says: "It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight!"
In my opinion, the most important thing any of us can do as investors is to learn from experience. With this in mind, using the "Reminiscences..." book and other research material from Charlie Munger, amongst others -- whose "Psychology of Human Misjudgement" speech at Harvard Law School, is an essential read -- I put together a list of ten psychological traps to avoid when investing. There are many more, but if I can start by lessening the impact of these top ten, I'll be a better investor:
1. An open mind
Confirmation bias is a tendency for human beings to confirm their preconceptions or hypotheses, independently of whether or not they are true. In other words, your mind has a natural tendency to think it's right. This is dangerous. Try and keep an open mind, and deliberately seek out opposing viewpoints.
2. Denial
None of us like to be proved wrong. And psychologists tell us that people find it difficult to change their opinions once they have been formed because of a reluctance to search for evidence that contradicts what they believe to be true. Again, this is a dangerous trap for investors to fall into.
3. Regret
Édith Piaf said it best: "Non, je ne regrette rien". Jesse Livermore agreed. He never spent time worrying about what went wrong, but tried to learn from his mistakes -- until he shot himself that is! Regrets aren't helpful, but learning from your mistakes is.
4. Big picture
Have you ever noticed how expert economists are always right in hindsight? They look at the evidence and say why XYZ happened. But what about the future? History shows us that the unexpected will happen, so don't be too narrow-minded in focussing only on relatively recent trends and developments. If we listened to the experts and pundits all the time, we really would be in trouble!
5. Overconfidence
Things are going great guns. Every investment you make goes up quickly, and you're making money hand over fist thanks to your "shrewdness". Consequently, you think you're a world-beater and begin counting your profits before they're real. This leads to overtrading. We've all been here at happy moments, and we've all been proved wrong. Overconfidence is the enemy of long-term success.
6. Gambling
Gambling is overconfidence's more sinister cousin. The stock market isn't a giant casino, but many traders treat it as such. It's said that the bookies love a first-time winner, because s/he'll always be back for more having tasted success. A compulsion towards gambling is a powerful and sinister force in many people. Fight against it.
7. Under-confidence
The flip-side of number 5. Warren Buffett sums it up with: "Be cautious when others are greedy; be greedy when others are cautious".
8. Dr Spock
Similar to 1 and 2, Dr Spock's objective and rational approach keeping emotion out of the way can help avoid investing traps. If the cold hard numbers don't stack up, try not to make the investment fit anyway. As the man said, "it's illogical".
9. Hindsight
Have you ever been to the races, had a look at the form of all the horses in the race and made your pick -- then, when one of the others (inevitably...) wins you think to yourself "I was going to back that one. Doh!!!" Because of course, you did consider the winner and probably came close to picking it, but in the end made another choice.
On the rare occasion that you're actually successful in picking the winner, you think, "I KNEW that was going to win. Why didn't I put a decent amount on it!? Doh!" In other words, people deceive themselves in hindsight -- which helps create bad decisions next time around.
10. Balance
Balance in all things; you hear so much contrasting advice and evidence about being a successful investor that, in the end, you make your choices on the balance of probabilities, and to try and balance out all this kind of psycho-babble -- or let someone else do that for you. Good luck...
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