Almost everyone finds finance difficult

Almost everyone finds finance difficult.

Yet, finds finance is the most important thing in life.

Usually, while investing—or anything to do with finance, for that matter—most make the mistake of using their emotions to take decisions. This is why theories suggested by traditional economics and finance rarely work in real life. There are eight mistakes investors commonly make. Here’s a look:

1.      Anchoring: When a ship wants to stop sailing, it drops anchor onto the seabed, which stops the ship from moving. Similarly, investors often base their opinion (of a particular stock) on a recent price, trend or notion. This, though, may not have a direct bearing on the future price of the stock. This is called anchoring. For example, if stocks of a particular sector start falling, investors tend to sell the stocks of even the stronger companies from the sector. This is because they baselessly anchor their decisions to the price trend of other stocks in the industry, without objectively thinking and realizing that some companies may actually be good.

2.      Mental accounting: Often, you may channelize your money into separate account depending on the end use, like vacation, tax investment, retirement and so on. In such cases, your mentality towards the end-use may affect how you manage the different accounts. This should be essentially avoided and could lead to problems in how you achieve the financial goals.

3.      Confirmation and hindsight bias: Confirmation bias is a situation where you already have a preconceived notion or idea about something. This results in you selecting stocks on the basis of incorrect and loss-making notions. Hindsight bias, meanwhile, is the habit of looking back at things and thinking they were much more obvious to see than they actually were. It is the guilt you feel thinking that you could have made more profit in the past since things were obvious and yet you failed to noticed it. For example, an investor makes big losses because he couldn’t see a pattern developing. Upon looking back, he feels the pattern was very obvious to see. This makes him less confident about his ability and exposes him to similar losses in the future.

4.      Gambler’s fallacy: Gambler’s fallacy refers to the tendency among investors to ignore probability and crude facts. Instead, they rely upon existing patterns to make dangerous bets. The tendency to gamble in stock trading is common and really dangerous, as it could lead to great losses. For example, as an investor, you may think that a lot of bad things have already happened to a company, and so, only good things can happen going forward. This leads you to take a risky gamble on the company’s shares, even though facts suggest otherwise. As a result you could end up with huge losses.

5.      Herd behavior: An Investor tends to follow the crowd because he feels that is the right way to go about it. Even the best of investors have fallen prey to this tendency. George Soros, the multi-billionaire hedge-fund manager, dismissed the Information Technology (IT) boom of the 90’s decade as a fad that will pass soon. As IT stocks kept rising and everybody around him started making tons of money, he started getting itchy. Consequently, in the late 90s, he bought some IT stocks at close to their lifetime highs. The IT bubble burst soon after and he ended up making massive losses. This blind faith leads to false hopes being dashed once the market price crashes.

6.      Overconfidence: Sometimes, investors tend to overestimate his or her understanding of the markets. They become arrogant about being better able to pick stocks than others. This tendency is particularly likely when the investor makes profits right from the time he/she starts investing. This makes the investor more aggressive. He/she starts taking bigger risks in the hope of making more money than anybody else. Eventually, it all leads to a downfall.

7.      Overreaction and availability bias: Often, investors tend to react only to those events or pieces of news that are recent, most dramatic or most relevant to him/her. For example, bigger the news, greater is the panic. Such an over-board reaction causes him or her to sell or buy without a second thought. This leads to great volatility in stock prices in the market, resulting in avoidable losses. Taking a more objective account of the situation before reacting to it can go a long way.

8.      Prospect theory: It is easy for investors to worry about small losses. This often stops them buy betting on a bigger profit. So, small losses weigh over bigger profits. As a result, the investor will settle for a low-risk, low-return option instead of a high-profit option which comes with the risk of a small loss. So, the investor often holds on to poor stocks instead of selling them and investing in other stocks that promise positive returns.

Happy Investing