Michael J. Mauboussin offers great advice to avoid the dreaded market despair:
Knowing yourself means understanding how you?re likely to behave under various circumstances. Over the past couple of decades, behavioral finance researchers have developed a clearer understanding of the psychological traps investors fall in. The best way for you to avoid these traps is to become aware of them, the forms they take, and which you are most likely to fall into.
Here are five common pitfalls:
- Over-confidence. Researchers have found that people consistently overrate their abilities, knowledge, and skill; especially in areas outside of their expertise. Investors must seek and weigh quality feedback and stay within their circle of competence.
- Anchoring and adjusting. In considering a decision, we often give disproportionate weight to the first information we receive, hence anchoring our subsequent thoughts. You can mitigate this risk by seeking information from a variety of sources and viewing various perspectives.
- Improper framing. The decisions of investors are affected by how a problem, or set of circumstances, is presented. Even the same problem framed in different, and objectively equal, ways can cause people to make different choices. Framing, too, plays a central role in assessing probabilities.
- Irrational escalation of a commitment. Investors tend to make choices that justify past decisions, even when circumstances change. To avoid this trap, investors must only consider future costs and benefits.
- Confirmation trap. Investors tend to seek out information that supports their existing point of view while avoiding information that contradicts their opinion. Psychologist Thane Pittman’s slip of tongue sums it up: “I’ll see it when I believe it.”
You must also understand how you tend to react under stress. People with different personality profiles behave in dissimilar ways when stressed. Here again, self-awareness and some basic techniques to offset suboptimal behavior go a long way. Pearson declares, “A gambler’s ace is his ability to think clearly under stress. That’s very important, because, you see, fear is the basis of all mankind….That’s life. Everything’s mental in life.”