Want to invest like a pro and make a fortune? Investing like a professional means doing thorough research before developing a plan in order to make informed decisions. But even if you choose the right strategy and the right securities, the game is far from won. There’s another – perhaps less obvious, but crucial – factor that plays a huge role in how you invest: behavioural finance and investing bias.
Behavioural finance is the study of human behaviour in the context of investing. It explains how emotions can interfere with financial decisions and undermine investor success. How do successful investors master the behavioural aspect of finance, as well as the technicalities of investment decisions? Here are some cognitive biases related to finance that pros know to avoid.
Overconfidence is the tendency of investors to overestimate their own skills and underestimate the risks associated with investing. For example, investors often invest large amounts of money in an opportunity after reading a summary article or having a discussion with a friend about the bullish potential of an investment. This can cause small investors to trade on sketchy, incomplete or insufficient data. When the other side of the trade may be a seasoned institutional investor who knows all the important aspects of a trade, this leads to mixed or, at best, random success.
Loss Aversion Bias
In 2002, Dr. Daniel Kahneman won the Nobel Prize in Economics by demonstrating that a financial loss causes twice as much psychological pain as the equivalent financial gain can bring in psychological pleasure. This behaviour causes investors to make bad decisions when markets go up or down.
Confirmation bias is the tendency to seek out and interpret information in a way that confirms one’s beliefs or opinions. For example, if an investor believes that the market will decline in the next few months, he or she will tend to read and favour articles that predict economic downturns and dismiss those that are more optimistic.
Herd mentality and fear of missing out (FOMO) are very powerful human emotions. Evolution has ingrained in human psychology that it’s easier to survive as a group than as a lone wolf. Financial bubbles like the tech bubble of 2000, the real estate bubble of 2008, and the cryptocurrency bubble are excellent demonstrations of the perverse effects of the herd mentality; especially since the news media tends to be sensationalist, amplifying FOMO and herd mentality.
Focusing on the Short Term
Although it’s best to have a long-term investing horizon to be successful it doesn’t always work out that way. Patience and discipline are difficult virtues to master, and the short term is much more concrete.
So how do we keep our emotions in check? We have to think like entrepreneurs.
If you think great investors have their eyes glued to financial applications from morning to night, think again. Pro investors like Warren Buffet analyze companies’ financial statements to find new robust and profitable business plans.
And like any activity, if you want to excel, you must practise.
If you spend your time glued to your screen, watching stocks and markets fluctuate, you are training yourself to think short-term. This unfortunate habit is unlikely to build wealth, but very likely to cause stress, depending on where the market goes. It’s easy to get addicted to the ups and downs, but it will be at the expense of your mental and financial health.
Instead of following financial gossip or listening to so-called “gurus”, great investors focus on specialized media that list the facts. What’s more, search engine algorithms can suggest articles that are based on cookies from your internet browsing profile and can flood you with articles that only amplify cognitive biases.
A good investor must learn to build psychological barriers to make informed decisions and not be distracted or swayed by the chatter and gossip of the markets. This is not always easy, even for financial professionals. In fact, the more powerful the trend, the more its propaganda effect spreads into financial normalcy and breaks down investor protection mechanisms. To be a good investor, you have to be able to separate the wheat from the chaff when it comes to financial information.
Entrepreneurs make their fortune by seeing their businesses grow over time. That’s why it’s best to keep an entrepreneurial mindset when it comes to investing. When we think of the great fortunes in Quebec such as the Péladeaus, the Rossis, and the Desmarais, we think of generational businesses that have been built over decades. If they had sold their businesses in the beginning, would they have amassed as much money? Did they have the urgency to sell their businesses at every economic downturn? No.
However, investors have a significant advantage over entrepreneurs, in that they can diversify their investments across different countries, industries, and companies so that they are not at the mercy of the specific risks of each company.
Claret is a portfolio management firm where entrepreneurship is of paramount importance. We have an entrepreneurial attitude and access to a multitude of financial tools to build successful portfolios that meet the specific needs of our clients. We also have the ability and experience to educate our clients to avoid the psychological pitfalls of investing so that they can make informed decisions to make their money grow.