Lesson 7: Identifying “trade traps”
There have been many authors who have written on psychological or behavioral
traps that lead people in the wrong direction with their lives in general. Quite
frequently, some classic forms of dysfunctional psychology are directly evident in
investing behavior.
We will take a look at some of the most common psychological traps to investing and
how to avoid them.
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. 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.
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.
The sunk cost trap is just as dangerous. This is about psychologically 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. 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.
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.
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.
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.
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, but if you are a modest earning and nervy person, this is not for you.
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.
Here we see a simple example of how history doesn’t repeat itself. This screenshot
shows a once in a lifetime event in the Euro-Swiss currency pair.
There will always be ups and downs, overheated stocks, bubbles, mini-bubbles,
industry wide losses, panic selling in Asia and other unexpected events in the
market. Believing that the past predicts the future is a sign of overconfidence. When
enough investors are overconfident, we have the conditions of Greenspan's famous,
"irrational exuberance," where investor overconfidence pumps the market up to the
point where a huge correction is inevitable. The investors who get hit the hardest —
the ones who are still all-in just before the correction — are the overconfident ones
who are sure that the bull run will last forever. Trusting that a bull won't turn on you is
a sure way to get yourself gored.
The phrase “Pseudo-Certainty Trap” is an observation about investors' perceptions
of risk. Investors will limit their risk exposure if they think their portfolio/investing
returns will be positive – essentially protecting the lead – but they will seek more and
more risk if it looks like they are heading for a loss.
Basically, investors avoid risk when their portfolios are performing well and could
bear more, and they seek risk when their portfolios are floundering and don't need
more exposure to possible losses. This is largely due to the mentality of winning it all
back. Investors are willing to raise the stakes to "reclaim" capital, but not to create
more capital. It’s like a race car driver that only used his brakes when he has the
lead.
In the final analysis, human psychology is a dangerous thing, and there are some
alarmingly standard mistakes that people make again and again. Be aware of the
nature of these traps and always be honest and realistic with yourself. Furthermore,
seek advice from competent and knowledgeable people of integrity who will bring
you back to reality before it is too late.