Psychological Traps
- Anchoring Trap
First, there is the so-called anchoring trap, which refers to an over-reliance on what one originally thinks. Imagine betting on a boxing match and choosing the fighter purely by who has thrown the most punches in their last five fights. You may come out all right by picking the statistically more-active fighter, but the fighter with the least punches may have won five bouts by first-round knockouts. Clearly, any metric can become meaningless when it is taken out of context.
For instance, if you think of a certain company as successful, you may be too confident that its stocks are a good bet. This preconception may be totally incorrect in the prevailing situation or at some point in the future.
Take, for example, electronics retailer Radio Shack. Once a thriving seller of personal electronics and gadgets in the 1980s and 1990s, the chain was crushed by online retailers such as Amazon (AMZN). Those trapped in the perception that Radio Shack was there to stay lost a lot of money as the company filed for bankruptcy multiple times and shrinking from its heyday size of 7,300 stores to 70 outlets by the end of 2017.1
In order to avoid this trap, you need to remain flexible in your thinking and open to new sources of information, while understanding the reality that any company can be here today and gone tomorrow. Any manager can disappear too, for that matter.
#2. Sunk Cost Trap
The sunk cost trap is just as dangerous. This is about psychologically (but not in reality) protecting your previous choices or decisions — which is often disastrous for your investments. It is truly hard to take a loss and/or accept that you made the wrong choices or allowed someone else to make them for you. But if your investment is no good, or sinking fast, the sooner you get out of it and into something more promising, the better.
If you clung to stocks that you bought in 1999 at the height of the dot.com boom, you would have had to wait a decade to break even, and that is for non-technology stocks.2 It's far better not to cling to the sunk cost and to get into other assets classes that are moving up fast. Emotional commitment to bad investments just makes things worse.
#3. Confirmation Trap
Similarly, in the confirmation trap, people often seek out others who have made and are still making, the same mistake. Make sure you get objective advice from fresh sources, rather than consulting the person who gave you the bad advice in the first place. If you find yourself saying something like, "Our stocks have dropped by 30 percent, but it’s surely best just to hang onto them, isn’t it?" then you are seeking confirmation from some other unfortunate investor in the same situation. You can comfort each other in the short run, but it’s just self-delusion.
#4. Blindness Trap
Situational blindness can exacerbate the situation. Even people who are not specifically seeking confirmation often just shut out the prevailing market realities in order to do nothing and postpone the evil day when the losses just have to be confronted.
If you know deep down that there is a problem with your investments, such as a major scandal at the company or market warnings, but you read everything online except for the financial headlines, then you are probably suffering from this blinder effect.
#5. Relativity Trap
The relativity trap is also there waiting to lead you astray. Everyone has a different psychological make-up, combined with a unique set of circumstances extending to work, family, career prospects and likely inheritances. This means that although you need to be aware of what others are doing and saying, their situation and views are not necessarily relevant outside their own context.
"I think a lot of people tend to equate their self worth with their income, or they think that social media, these days puts pressure on people to make it look like they're doing better than they are. And because of that, people feel bad," said Amy Morin, Verywell Mind’s editor-in-chief. "We look at somebody else who has a new car or somebody else whose house looks beautiful and think, 'Oh, why don't I have that?' And those emotions that get stirred up, I think for a lot of people are really difficult. Then how do you decide what you really value in life and what's most important?"
Be aware, but beware too! You must invest for yourself and only in your own context. Your friends may have both the money and the risk-friendliness to speculate in pork belly futures (as in the movie Trading Places), but if you are a modest earning and nervy person, this is not for you.
#6. Irrational Exuberance Trap
When investors start believing that the past equals the future, they are acting as if there is no uncertainty in the market. Unfortunately, uncertainty never vanishes.
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