What’s an investing trap?
There are two kinds of investing traps—cognitive and emotional—but they’re often lumped together and simply called “behavioral biases.” A bias is a mostly unconscious predisposition to think or behave a certain way, in a given situation. For investors, it’s easy to get trapped by biases because investing always involves incomplete information and a range of probabilities.
There are many aspects of investing that are out of our control; we hope for a certain outcome, but we can never be sure. Biases are the lazy shortcuts we use to make investing decisions. Emotional biases are more stubborn than cognitive biases.
Rule number one: Don’t lose money. Rule number two: Don’t forget rule number one.
Overconfidence
When is confidence a bad thing? When it veers into overconfidence, one of the deadliest investing traps. Overconfident investors over-estimate their abilities and are too optimistic about exceptionally positive outcomes, without considering the full range of probabilities. Consequently, overconfidence bias leads to a bunch of mistakes, such as impulsive decision-making, taking on more risk than one can afford, and excessive trading that eats into returns.
How to Avoid the Trap: Keep a journal of your investment decisions, including your rationale for making a certain choice. What were the outcomes of these choices? Review these choices and outcomes periodically to see if there’s a negative pattern.
FOMO
Who is TINA FOMO? She’s an investing trap waiting to happen, that’s who. TINA is the acronym for “there is no alternative” and FOMO stands for “fear of missing out.” Both of these biases trip investors up because they lead to herd behavior. For example, in an era of low interest rates, investors tend to believe there is no alternative but to invest in stocks, even at high valuations. (There’s always an alternative, it’s called ‘cash.’) Consequently, a small sub-set of the stock market, the FAANGs (Facebook, Amazon, Apple, Netflix, Google), have attracted most investor dollars. Due to popular demand, their stock prices have risen and are now “priced for perfection.”
Ready to buy into the FAANGs, even at a sky-high price? Steady your mouse pad. One stumble of bad news will cause their prices to fall, punishing investors who joined the crowd too late.
How to Avoid the Trap: Tactics against this trap are three-fold.
- Be very wary of “hot tips.” Your Uber driver, personal trainer, and the talking heads on TV business news shows—everyone purports to have inside information on a great investment idea and the chance to make fast gains. Here’s a real tip: Assume that by time you know about a stock investing idea, everyone knows too, and their expectations are baked into the price.
- Realize that popular stocks are expensive, and maybe not worth their price point in the long run
- Have an investment plan and stick to it, no matter what the herd is doing
Anchoring
First impressions matter. Sometimes too much. Anchoring occurs when we set an arbitrary value on a house or a stock, and then keep using it as a reference point. For example, if ABC stock once reached $100 per share, we reference that historical information and falsely assume it will reach or exceed that price again, even though it may have been overpriced before or the company may have since changed in some fundamental way.
How to Avoid the Trap: Always remember the simple adage, “past performance is no guarantee of future results.”
Familiarity
We’re more likely to choose things we’re already familiar with. That’s why brands spend millions on advertising. But familiarity bias is an investing trap, because it might lead us to ignore other, perhaps worthier investments simply because they’re unfamiliar to us. This is one reason why people make the mistake of buying a lot of stock in the companies they work for, thus doubling their risk if the company does poorly and they lose their jobs as a result. It also leads to “home bias”, forfeiting the risk-managing benefits of diversification by focusing only on the domestic market.
How to Avoid the Trap: Evaluate potential investments on their objective merits, not on your emotional comfort or identification with them.
Confirmation
We each hold certain beliefs and are reluctant to let facts get in the way. If we believe that tech IPOs (initial public offering) always make money, we’ll likely pile on at any price based on the expectation of a big payoff by time markets close at 4pm. We only look for and notice examples that confirm our hypothesis, not the ones that don’t.
How to Avoid the Trap: Always challenge yourself by creating a counter-argument to your thesis. For example, “Tech IPOs are always easy money for investors.” “Oh yeah, what about Facebook?”
Endowment
When we own something, we create an emotional connection with it and tend to overvalue it as a result—whether it’s grandma’s wedding ring or shares of General Electric. The endowment effect is an investing trap that causes us to hang on to something because letting it go would cause us emotional pain. We cling to unprofitable or inappropriate investments even when our money could be put to better use.
How to Avoid the Trap: The best way to address this emotional bias is to consider what the opportunity cost of holding the current investment is and whether your money could find a better return elsewhere.
Status Quo
As investors, we have to be right twice: once when we buy and again when we sell. What if the timing is wrong? What if the stock keeps going up (or down)? These are tough decisions because the outcome is uncertain. Sometimes it’s easier to do nothing at all and just maintain the status quo. This investing trap causes people to avoid making any investment decisions at all for fear of incurring a loss (loss aversion), and feeling regret (regret avoidance). We hold on to our losing investments instead of heading for greener pastures.
How to Avoid the Trap: To overcome status quo bias, try the reversal test: if you could go back in time, would you buy the same investment?
Get Help
A successful investor also knows when to ask for help. If you’re new to investing and need a bit of a helping hand or just don’t have the time to check how the stock market is doing every day, a robo-advisor is the way to go. Robo-advisors like Questwealth Portfolios (which is the robo-advisor wing of Questrade) or Wealthsimple are taking over the investing world by storm, with incredibly low fees and returns that are as good (or even better) than much higher priced full-service, brick-and-mortar investment firms. To set up a portfolio with a robo-advisor, all you have to do is answer a few questions that assess your risk aversion levels and outline your investment goals. Your robo-advisor will set up and then manage and readjust your investments automatically so you don’t have to worry about a thing.
If you want to be a hands-on investor and create and manage your own portfolio but don’t want to pay high fees, Wealthsimple Trade—Canada’s first and only commission-free investment broker—is a worthy choice. While Wealthsimple Trade’s approach is more no frills than full-service firms, it nonetheless gives you access to a large array of Canadian and U.S. stocks. For a limited time, get a $25 cash bonus when you open a Wealthsimple Trade account and fund at least $150. Sign-up today to take advantage of this exclusive offer! It’s the ideal stock trading solution for do-it-yourself investors who are looking for commission-free trading, with no account minimums.
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