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Overreacting to news and events
Investors often overreact to news and events, swinging between extreme excitement and panic, much like a group mood swing caused by a headline. It’s important to remember that news can be biased and might not always come from experts. Also, it often doesn’t give the full picture needed to make smart investment choices.
Keep in mind that those who provide information often have their own agendas and may not prioritize your interests. News is frequently tailored to shock and draw attention, serving the media’s goal to engage audiences. For instance, even factual news, like Elon Musk purchasing Twitter or endorsing Dogecoin, should not dictate your investment actions. Whether to buy or sell based on such news requires careful consideration.
Often, a single piece of news shouldn’t sway your investment strategy, especially if it’s built on thorough, long-term research. Overreacting may indicate a lack of confidence in your preparatory work. Solid preparation, experience, and emotional steadiness are your best defenses against such overreactions.
It’s vital to have a well-thought-out plan and remain composed, even when unexpected changes occur. Refer back to your strategy that includes contingencies for various scenarios. This approach helps you maintain control over your decisions rather than being led by external events. Nassim Taleb’s concept in “The Black Swan” underscores the importance of being ready for unlikely and impactful events through robust mental preparation and strategic planning.
Availability bias
We’ll now explore “availability bias,” a tendency to prioritize information that is easily accessible or prominently displayed. This psychological pattern often leads us to gravitate towards things that are front and center, whether due to frequent advertising or media coverage. In the context of investing, this refers to the tendency to invest in popular, widely discussed ideas or products.
Cryptocurrencies, especially Bitcoin, provide a clear example. In recent years, the surge in Bitcoin’s popularity has led many to invest simply because it’s a frequent topic of conversation. Often, these investments are made without proper research or a careful assessment of potential risks. Instead, influenced by availability bias, individuals may rely too heavily on readily available information, which isn’t the smartest move when a lot of money is at stake.
This bias is also evident among investors who depend solely on a single information source to make decisions, limiting their perspective. Relying on just one news source, for instance, can twist an investor’s understanding of the market, as the information obtained may not be comprehensive or objective. It’s important for investors to seek diverse sources to form a well-rounded view and make informed decisions.
Endowment effect
I’d like to conclude with an explanation of a psychological phenomenon known as the “endowment effect.”
The endowment effect describes how people often value things they own more highly and struggle to part with them. This attachment can lead to holding onto assets or items long past their optimal usefulness. In the realm of investing, this effect can make us hesitant to sell assets we’ve held for a long time, even when all signs suggest it’s time to let go. This bias can cause us to overestimate the value of our possessions and become overly subjective.
To resist the endowment effect in investing, it’s crucial to assess assets objectively.Investors should prepare to respond to market changes instead of becoming emotionally attached to their holdings. Setting independent criteria for evaluating assets at regular intervals can help. If an asset no longer meets these criteria and shows no signs of improvement, it might be time to consider selling, even if it feels challenging.
Interesting research, such as the studies described by Harvard psychologist Daniel Gilbert, shows this effect. In one experiment, individuals received coffee mugs and later received offers to sell them at a price higher than the market value. Despite the potential profit, many chose to keep their mugs, demonstrating the powerful hold of the endowment effect.
To summarize
The journey of investing is fraught with psychological traps that can potentially undermine our efforts. Yet, despite these challenges, many investors succeed and prove that these obstacles can be overcome. One effective strategy is to familiarize ourselves with these psychological biases—a task we’re undertaking here. Understanding these mental patterns helps us combat them more effectively than if they were unknown threats.
Researchers have well-documented these cognitive tendencies, and you can easily find information about them online, especially in the context of investing. With this knowledge readily available, we have no excuse for being unprepared.
Additionally, preparation is crucial for tackling these challenges effectively. As I’ve previously emphasized, the secret is to be proactive and plan ahead. Developing a strategy while in a calm and thoughtful state, and training your mind through practice, allows you to handle the complexities of investing with confidence. Being well-prepared means you can address unexpected challenges instinctively and efficiently when it matters most.