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The Psychological Dynamics of Investment
You already know how passionate I am about the psychology of investing and how I believe it is of the utmost importance to success in investment endeavors. The circle of self-knowledge, investment, self-improvement, success and failure continues to excite me. I see investment activity not only as a means of making money and creating wealth, but also as an opportunity to better understand how the human mind works. I believe that anything that provokes, delights or worries me can be used not only to provoke reactions in me, but also to enhance and analyze those reactions.
Instincts in Action
It is not always best to act on instinct, but sometimes it is. There is much literature discussing how the development and training of professionals can teach them to act instinctively in certain situations, and this is considered a great advantage. Examples of this can be found in sports. One of the main principles American football coach Pete Carroll has implemented and encouraged in the Seattle Seahawks team since taking over in 2010, is to teach players to react instinctively. It aims to reduce thinking time in the moments when players need to react. This improves the game for several reasons.
- First, it eliminates the possibility of excessive thinking or “overthinking”. If the player begins to think about how to play the ball instead of just playing it, the likelihood of error increases.
- Second, the elimination of thinking helps concentration and quick reaction in the development of the game.
- And third, when players act instinctively, they build greater confidence in their abilities, which affects their play.
Carroll’s approach is paying off, and his team has gone from one of the weakest in the league to having significant success.
You may be familiar with my approach across various platforms—articles, podcasts, and training sessions—where I consistently promote critical thinking. So, why am I exploring the concepts of instinct and automatic responses in this article? Is there a contradiction here? Not at all. The objective is to understand that effective training enables a person to accurately assess situations and respond appropriately. I’m not advocating for less thinking; instead, I encourage thorough contemplation during the learning phase when there is no pressure to react swiftly. This is the ideal time for deep reflection, developing responses, and honing instincts.
Preparation and Response
In this article, my goal is to familiarize you with a framework of behavioral decisions and psychological approaches tailored to investing. The strategy is straightforward: we’ll tackle the thinking and learning upfront. Then, when real-time situations arise, you’ll be able to respond with the speed and precision of a well-trained athlete, much like a Seattle Seahawks player under Coach Carroll, adeptly navigating the complexities of investment decisions.
I’m a big believer in advance preparation and a plan. This plan includes knowledge of both the emotional states people fall into when investing and the traps our own brains can lead us into. Let’s start looking at these aspects one by one.
The principle of following the herd
Investors often follow the actions of others instead of making independent decisions or doing their own research beforehand. It’s not wise to rely too heavily on others or to skip doing your homework. Just because many people behave in a certain way doesn’t necessarily mean it’s the right choice. There’s a well-known investing saying: “Buy when others are fearful and sell when others are greedy.” This advice challenges our natural instincts, which often lead us to follow the crowd because it feels safer. We think to ourselves, “If everyone else is doing it, who am I to go against the flow?”
We won’t debate whether it’s always right to follow the majority. The key is to remember this tendency and make your decisions thoughtfully on your own. Don’t succumb to the psychological pressure to conform, which stems from our social need to fit in; resisting this can feel uncomfortable and unnatural.
Additionally, we often act like others because we doubt our own abilities and assume that a large group must know more than we do individually. In reality, many in the group are just like us, choosing a path simply because others are taking it. Therefore, it’s important to learn to trust your own judgment and stand by it, despite the psychological pressures. Being true to yourself requires both preparation and experience.
Overconfidence bias
Overconfidence bias happens when investors get too sure of themselves, leading them to take big risks and make mistakes. When someone is overconfident, they often overlook warning signs, underestimate risks, and make choices that aren’t backed up by the facts.
One reason people become overconfident is from having success in the past. Making money from investments might boost someone’s pride and confidence, sometimes without them realizing whether their success came from real skill or just luck. Even if you do have special skills, it’s important to look at each new situation on its own because past success doesn’t guarantee future results. While being confident is generally good and can be helpful in many areas of life, being too confident can backfire badly.
This is especially true for new investors, who might experience what’s called the Dunning-Kruger effect. This is named after two American social psychologists who found that people often feel more confident when they just start a new activity. For example, children are more likely to scrape their knees soon after they start riding a bike on their own because they quickly think it’s easy. Similarly, new investors might feel overly confident after their first few successes.
It’s important to be aware of the overconfidence trap because it can catch almost anyone. You should celebrate your successes, but don’t let it go to your head because that can lead to unrealistic expectations and decisions you might regret later. Balancing confidence with a healthy dose of self-criticism can help you make better decisions and keep a realistic view of your investments.
