The Psychology Of Investing. How To Avoid Losing.

“The majority is always wrong; the minority is rarely right.” A lasting quote from Norwegian playwright Henrik Ibsen. A concept I buy very much into. It’s much like the Pareto Principle, also known as the 80/20 rule, which states that roughly 80% of the effects come from 20% of the causes.

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How The Financial Brain Works

The principle frequently serves as a benchmark for planning, prioritization, and decision-making. Individuals and organizations can make more informed and effective decisions and concentrate their efforts in the areas that are most likely to result in meaningful results by identifying the primary elements that account for most of the outcomes. I apply this principle to most of my life, sometimes unsuccessfully, but when I do, I become much more efficient and productive. I also apply this to investing. Of course, I analyze the numbers and projections, and most, like me, can do that to a certain extent. However, what I have found over the years is that having an analytical edge isn’t enough. The market environment, technology, social media, and the availability of systems that know how companies are performing in real time, put us all at a disadvantage. As well as this, focusing on the behavioral aspect of the investment is just as, if not more, important than analytics. Concentrating on this area at the very least can limit your losses.

Do you consider yourself to be a sane investor? Most individuals do. However, we are all emotional creatures. We frequently make fast, stupid decisions due to our thinking, which results in subpar performance or losses. Surprisingly, most people are correct in their investment decisions, but timing, market movement, fear, and greed can ruin any sort of potential positive return. Frequently, it comes down to emotion. Investors tend to lose not because of economic conditions but because of human psychology.

Although some people experience enormous stress because of money worries and the fear of losing their fortune, it is not true to say that this is the greatest worry that all people experience. Fear is a complex emotion that can vary greatly depending on factors like environment, culture, and prior experiences. Many people's fears of losing money may be rooted in their sense of insecurity and belief that doing so could lead to undesirable outcomes like poverty or social exclusion. However, other phobias can be equally strong and widespread, such as the fear of failure, public speaking, or even death.

Additionally, it's critical to keep in mind that a person's level of financial stress can vary significantly depending on their individual circumstances, including their financial situation, stage of life, and personal priorities. For instance, someone who has gone through a severe financial struggle may be more afraid of losing money than someone who has not experienced such difficulties.

Attention, perception, memory, and decision-making are just a few of the cognitive processes that the brain uses when processing financial data. The brain engages neural circuits that assist in processing and analyzing financial information. For instance, the prefrontal cortex, a region of the brain in charge of executive function, attention, and decision-making, is strongly engaged while making financial decisions. When people suffer financial stress or anxiety, the amygdala, a region of the brain responsible for processing emotions, is also triggered. Additionally, the brain's reward system, which dopamine activates, influences how we make financial decisions. When people receive money or experience financial gains, the brain releases dopamine, which gives them a sense of pleasure and reward.

In brief conclusion, it is not true to suggest that the greatest fear of all humans is money, even though it can be a substantial source of worry and anxiety for some people. People's unique experiences and circumstances can affect their fears and priorities because fear is a complicated emotion influenced by many variables.

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The Psychology Of The Stock Market

The psychology of the market refers to the role that human behavior and emotions play in shaping market trends and investor decision-making. Everything in the world moves in cycles. Seasonal cycles, ecological cycles, geological cycles, technological cycles, economic cycles, and ever smaller cycles like relationship cycles. Did you feel like things started to get better after that huge argument with your partner? No? Give it time; it will.

Companies and markets fluctuate with economics, performance, and investor sentiment. My view is that everything will have value in the long term. The trouble is, between that gap of investing at the price and the goal of realizing a return on your investment, many shorter-term influences can get in the way and cause you losses. Being able to recognize these cycles and emotional influences will get you up there with the greats and away from the masses. The analytical part is easy (ish).

As the legendary investor Benjamin Graham states, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

Why We Lose

In my 30+ years in the market, I have seen many cycles, bubbles, and downturns. My tested emotional intelligence (EI) score is off the charts, and so I have the uncanny ability to notice and process more than most, particularly in terms of people and the way they are likely to think due to their personalities as well as reactions to different situations, something I believe I inherited from my mom. As money is the sole driver in stock markets, it becomes a magnifying glass of reactions and emotions when events happen. It’s here, at extremes, where I consider myself to be at my best. My contrarian brain kicks in, and I spot investment opportunities. I have made my greatest investments with a contrarian lens.

I’ve seen fortunes made and fortunes lost throughout the years. Nothing, however, replaces consistency and hard work in maintaining your wealth. There are no get-rich-quick schemes. The dot-com era in 2000 was one of the most incredible experiences of my life so far. The fast rise in technology shares made millionaires overnight but also increased deception and fraud as the lust for greed increased. The collapse was something else. Stocks that went from nothing to some of the biggest companies in the world, such as Juniper Networks JNPR reaching such heady heights and then almost returning to dust within a year, were incredible to watch. Around 90% of dot-com stocks in that era went to zero, along with the profits of many investors.

Individuals frequently act irrationally and exhibit a wide range of reactions. For instance, many investors made large investments in internet-related stocks during the dot-com boom. However, many of these stocks lost value when the bubble burst, and many investors suffered sizable losses. The fear in 2001/2 was some of the greatest I’ve seen in markets, as fortunes were lost as fast as they were made. It took 12 years after that for the S&P to reach its previous high. Investors essentially went into what is known as the irrational exuberance trap. Which essentially means that unfounded market optimism lacks a real foundation of fundamental valuation, but instead rests on psychological factors. Remember, some of the worst losses in the stock market come naturally from buying stocks that are too highly priced. The surprising fact is that investors buy stocks knowing full well that they are overpriced but expecting to sell them to someone else at an even higher price. Their perception is based on the underlying ‘Greater Fool Theory’ which simply states that there will always be a “greater fool” in the market who will be ready to pay a price based on a higher valuation for an already overvalued asset. This is a huge gamble for investors and not one I recommend placing your hard-earned cash on, but it is a very common strategy for foolish investors that comes with irrational exuberance.

Investors' emotions swing wildly from optimism to pessimism, from greed to terror, from credulity to skepticism, and from risk tolerance to risk aversion. One memory stands out very clearly: when I visited a tech firm whose share price was on an incredible vertical move, the secretary was flicking through a Ferrari magazine. That characterized a lot of that period for me. It's not that I’m against well-paid secretaries, it was just an anomaly I wasn’t used to seeing. The truth about markets is that they are made up of people who come with all those human emotions, fears, and propensities for extremes.

What you must remember is that, on the face of it, no one loses in the stock market, and of course everyone wins. It’s like social media. When did you last put a photo up of your beat-up old car or a selfie in the morning after a rough night, other than for a joke? Never, of course. You want to show everyone that you are winning. The reality is that only a select few win long term. The 20%. That desire to win or show you are winning, or more importantly, not losing, can make you do things you wouldn’t normally do. Perhaps buy that new, exuberant car above your means or pay for extensive cosmetic surgery on credit that you may struggle to pay for. None of this is wrong, but understanding why you are doing it really matters. It’s the same for investing. We all don't want to lose, so if emotion instead of analysis drives your pursuit of these things, you might find that you lose more than you win. It’s this very emotion that leads us to take small profits, which we sing about, and large losses to keep quiet. Our vanity matters to the world. If you remember one thing, remember this. The markets were set up to fool you. They are there to take your money. Contrary to popular belief, you will never teach the market any sort of lesson. You must try to outsmart it, but that’s easier said than done.

Psychological Traps You Should Avoid

The ‘behavioral’ edge I often speak about can come in many forms. Just to clarify, your behavioral edge is one of two things that are essential for investing. The first is your analytical edge, which encompasses the numbers, and the second is your ‘behavioral’ one. Behavioral edge further has two subsections. The first is knowing that behavioral biases exist and can be exploited in markets. You need to know how different biases affect asset prices, where they can be easily found, and when they can be best exploited. This is where popular phrases such as “buy when others are selling” come in. A concept that everyone understands but few practice.

The second part is even more important for winning. Knowing that you are just as susceptible to these biases as everyone else. That includes overconfidence. Humans tend to overestimate their own abilities on the upside, and it’s a fact that they are overly pessimistic on the downside, but rarely does this pessimism ever play out as badly as they think. Hence the phrase “this will end in disaster,” and of course it very rarely does.

It’s also important to ensure you don’t influence that edge with your own cognitive biases. The tendency of the human brain to streamline information processing through a filter of personal experience and preferences results in cognitive bias, which is a systematic thought process. It’s something that could mean the difference between a good or bad investment if you don’t control it. The list of biases is extensive and serves as a good guideline to ensure you are less influenced by your brain’s emotions and more influenced by the facts as much as possible.

In 2020 through 2021, the world was exceptionally socially bored. We were amid the COVID pandemic. There was no traveling, no sports, activity was restricted, and the mental health and wellbeing of the public were raising concerns. People were frustrated and spent their money on new motor vehicles, recreational goods, furniture, appliances, and pets. All fueled by government stimulus checks and low cost or free loans. The absence of live sports betting caused the smaller investor to turn his attention to the stock market. As my good friend Spencer Jakab points out in his must-read book, "The Revolution That Wasn't: GameStop, Reddit, and the Fleecing of Small Investors,"

“Disrespect for traditional expertise was a driving factor at the time." People like Warren Buffett were cautious at the pandemic's onset, but brand-new influencers with no track record who used social media (Twitter, TikTok, and YouTube) weren't. Their advice turned out to be right, given the eventual return to normal and the incredible burst of fiscal and monetary stimulus”. He was correct, and it snowballed into a huge, popular stock rally in 2021. officially known as the meme rally.

Back to psychology, confirmation bias is a cognitive bias that is seen in every area of life and can be obvious in the stock market. When people look for information or proof that supports their previous views or hypotheses while ignoring information that contradicts them, this is known as the ‘confirmation trap’. You see it all the time, particularly on social media. On Twitter or Facebook, for example, you are likely to surround yourself with like-minded friends. Really, this serves no purpose other than your beliefs and, in some cases, your ego too. The truth can be far from what you and your group believe, as it chooses not to listen to anything else.

With investing, we saw a lot of this in the meme craze. Shares of a company that went viral due to a heightened social mood were referred to as "meme stocks." AMC and GameStop saw huge increases in their stock values. There were a lot of news stories about people raising the share prices that were not particularly profitable in general. Peloton PTON, Zoom ZM, Bed Bath & Beyond BBBY, and even Blackberry BB were companies that achieved lofty values that didn’t really justify their balance sheets, but investors, mainly the new and smaller ones, continued to purchase because they were convinced there was an upside. The greater fool theory in full swing.

Their knowledge came from online sources such as ‘Wallstreetbets’ (WSB) subreddit where participants discuss stock and option trading and used to gather in their thousands every morning. These investors would seek out stories and testimonials that supported their beliefs while ignoring or dismissing fundamental evidence that contradicted them. What was interesting to me was that the bias gained momentum, and by the end, it was difficult to know what was and wasn’t a ‘meme’ stock. All stocks were popular. If you owned one beforehand, consider yourself a lucky investor, as the price was catapulted higher for no apparent reason other than that it appeared to gain popularity suddenly. Looking back at the bubble, it’s an important lesson and a reason to examine what happened. Investors who held on to most of these names suddenly found themselves underwater. A combination of regulatory, market, and social factors contributed to the end of the meme stock phase. Regulatory agencies, including the Securities and Exchange Commission (SEC), started looking into possible market manipulation and other abuses related to social media-driven trading activity as meme stocks became more and more popular. Additionally, some social media platforms and online forums started to restrict conversations about meme stocks, which might have lessened their appeal to some investors, and the subsequent downturn left a lot of them feeling that their emotional investment in these stocks, which weren’t worth anything like what they paid for them, prevented them from taking a loss. It’s vanity, as I mentioned earlier, that is one of the single greatest enemies to stock market success, and confirmation bias, along with vanity, proved deadly. The collapse in meme names in 2022 contributed to the stock market’s worst fall since 2008.

This leads to the sunk cost trap. The bias happens when people keep devoting time, money, or other resources to a project by choice just because they have already devoted these things. This bias may influence individuals' judgment and result in the wasteful use of resources. This happens frequently when investors buy a stock and, consequently, the stock falls, and they feel like they must keep averaging because they have put "good money" in already. This is a real path to loss for investors. Ensuring disciplined stop losses according to your risk measures and a readiness to exit losing investments, when necessary rather than holding onto them indefinitely will help with this. We saw evidence of this playing out when the market reached its peak in December 2021. The following year was a rude awakening for investors in their own convictions. Their sinking cost has already pushed their average down. particularly on some of the meme names that fell very fast and ultimately ended in disaster as the realization dawned on them that price didn’t equal valuation and momentum was the only thing that was holding them up when the music stopped.

A lot of the meme phase was also based on the anchoring trap. This happens when someone bases too much of their decision or judgment on the first piece of information they are presented with. This can happen frequently to many investors as they go looking for something, find it, and act upon it without looking further. In the case of stocks, you might be looking for a cheap small-cap company in the industrials sector and stumble upon one that fits the bill, even though there could be multiple companies in the sector. To avoid falling into the anchoring trap, it is important to gather multiple sources of information, consider all relevant factors before deciding, and try to challenge your original thinking. Producing a relative value table will ensure you capture some of the chosen companies’ competitors, and carrying out further analysis may lead you to a better choice of investment. This trap can take many forms, and one of the more obvious ones is "buy" or "sell" levels. How often have you heard ‘$100 is the buy level’ or ‘$200 is the sell level"? Buyers and sellers are fixed or "anchored" to these prices. They will psychologically obsess over that price when determining when to buy or sell more of the same stock, regardless of the stock’s true value as determined by an evaluation of pertinent aspects or fundamentals affecting it. It is important to take a broader view of the situation and to consider a range of factors, such as market trends, company performance, and economic conditions, to avoid doing this.

Social Media

Have you ever noticed that some social media accounts just rely on the past for their assumptions and analysis? The relativity trap is a classic cognitive bias people bring to markets and investing. Instead of making an unbiased evaluation of the event itself, investors tend to assess the seriousness of a problem or scenario by comparing it to others. Personally, I never buy into this thinking, although the number of times I hear it is incredible. Macro guys are often the perpetrators of this type of bias. My experience leads me to believe that history does indeed repeat itself. Bubbles, manias, and crashes ultimately have the same effect, ending in loss of wealth, however, here is the key difference. They come in different disguises. From what I recall, the market has never reached its peak or bottom in the same scenario. It just doesn’t happen. Fear and greed are what happened, and these two traits are the same at both ends of the market, and they do indeed repeat.

It is crucial to assess issues and circumstances on their own merits, rather than in comparison to others, to avoid falling into the relativity trap. In addition, rather than becoming bogged down in comparisons to others, it can be beneficial to concentrate on solutions and activities that can be taken to solve the situation. Lastly, try to ignore social media that purports this sort of analysis. It can have a heavy influence.

Logical Vs Illogical

We live in a world today where illogical behavior can seem a bit smarter than logical behavior. Take Warren Buffett, for example. It’s obvious what he does. He even goes so far as to say what companies he looks for. He weeds out companies that appear to be trading below their true worth. He says that there isn't a single way to measure value. Businesses with long-term earning potential typically have steady profits, positive cash flow, and little debt. How easy is that? With this simple strategy and a bit of patience, he has become one of the best investors in the world. I mean, you can even copy his portfolio. Why do investors frequently choose to engage in wrongdoing that is the result of illogical behavior? The perception is that the chances of success are greatly enhanced by doing what seems illogical these days. You see this on a lot of social media. The dislike of Elon Musk, Jeff Bezos, and Mark Zuckerberg. They have built the best companies in the world, but there is a great following of people who just don’t like them or their businesses and read all sorts of stuff into why the business is bad, including complete fraud. Investors might view this as wisdom and bet on the share price falling, but it’s illogical.

The pseudo-certainty trap is along similar lines and is a trap many stubborn portfolio managers fall into. They tend to be extremely certain and reluctant to change their opinions because they feel overconfident in their own judgments and ideas. This also encompasses the blindness trap, also known as the "blind spot bias." It’s a cognitive bias in which people tend to believe that they are more objective and rational than other people and are unconscious of their own biases. This can impair their capacity to assess information and come to wise conclusions, as well as cause them to fail to understand their own limitations. It’s always good to get a second or alternative opinion on major decisions. The least you’ll do is ensure you are making a rational judgment.

In December 2012, well-known investor Bill Ackman and his fund Pershing Square Capital Management publicly attacked Herbalife, a nutritional supplement company, by wagering a stunning $1 billion ‘short’ bet against them, claiming that it was an illegal pyramid scheme that preyed on minorities and those with lower incomes. After numerous presentations and even a TV fight with legendary investor Carl Icahn, Ackman was still adamant he was right in his thinking when, in fact, the fundamentals showed otherwise. He was conducting an interview with CNBC, and Icahn called in to the show and blasted Ackman as a "liar" and a "crybaby." After a long-drawn-out battle with the company, which ultimately relied on opinion, Ackman ended up losing about $760 million in the short position. Ackman, to this day, bears the scars of his pseudo-certainty trap mindset. There is also evidence here of the superiority trap. Ackman appears to perceive himself better than most.

One of my greatest pieces of advice is to try your best to stay humble; otherwise, the market will take it upon itself to humble you. Lastly, maintaining a healthy skepticism and carefully weighing the risks and possible rewards of any investment or market are crucial for avoiding psychological traps. Do your research, keep it current, and always keep your eyes forward and never look back.

The way to win at investing is to do exactly the opposite of what nearly everyone else is doing.

By Jim Osman, Senior Contributor