Beginners guide to investing part 7: Don't let emotions rule

Emotions can be the enemy of good investing, in part 7 of my beginners guide to investing, I consider emotions and investing and what you must do.

Article updated: 13 November 2020 2:00pm Author: Michael Baxter

We are all emotional creatures; we are all biased; we are all prone to become victims of groupthink. An important part of becoming a successful investor is to recognise that we are no different from anybody else — we are just as vulnerable to emotions driving our investing.

Mind you; if you are different, it can help. When Michael Lewis investigated the 2008 crash in his book: The Big Short, he found that many of the traders who spotted the crisis in advance had quite unusual personality traits, including one investor he considered who suffered from Asperger's syndrome.

Let's start at the beginning.

Daniel Kahneman, in his brilliant book 'Thinking fast and slow', argued that we do precisely what the book's title suggested. We think fast and think slow. Fast thinking is instinctive; it is about our gut, sometimes obeying the hardwiring in our genes or following practices that have become hardwired into us. Slow thinking is logical, rational. Kahneman argued that fast thinking is more common than we realise and that we often use slow thinking as a kind of explanation in highlight. We fool ourselves into believing we reacted in a certain way out of considered, logical thought, when in fact, our reaction was instinctive.

The problem with thinking fast is that our instinct is vulnerable to all kinds of biases that can make us unsuccessful investors.

Here I focus on a handful of biases I think are especially important.

So beware:

  • Groupthink
  • Loss aversion/endowment effect
  • Confirmation and availability bias 
  • Anchoring
  • Inability to change one's mind

Groupthink 

All of us get sucked in by the crowd that surrounds us. When the consensus says one thing, it is hard to go against it. Some people think they have the knack of contrary thinking, but they merely become influenced by another crowd — so conspiracy theorists believe they go against the crowd. In fact, they become immersed in a group of likeminded people. 

There are plenty of examples of groupthink. The psychologist Solomon Ash showed that we are often more willing to be wrong than go against the crowd. Numerous studies show that the great and the good can get sucked into groupthink. A famous example is the Bay of Pigs disaster in which President JF Kennedy tried to orchestrate a coup in Cuba. He was later heard to remark, "How could I have been so stupid."

And groupthink can charge investment crazes and investment madness. I wrote about bubbles earlier in this series. Just remember that Isaac Newton got sucked into an investment craze and lost a lot of money. I am sure you are smart, but not many people can claim to be as smart as Isaac Newton was. So, if he can become a victim of groupthink, we can all be victims. 

Be aware of this risk; try to develop a habit of thinking like a contrarian. If the consensus is such and such, consider the possibility that the consensus is wrong.

Remember the comments by Warren Buffett: "Be fearful when others are greedy, and greedy when others are fearful."

Loss aversion/endowment effect

Studies show we tend to put more value on what we own. If we win a theatre ticket by random, we may for example attach more value on that ticket than if we were looking to buy it. This type of bias is known as the endowment effect.

The endowment effect means we may attach more value to shares we have previously bought than is rational.

Linked to this is loss aversion — if an investment is worth less than we paid for it, we may be reluctant to sell it, because we hate making a loss.

To overcome this bias, ask yourself this question about each share in your portfolio: "Would I buy this share if I didn't already own it?"

For more on loss aversion, see How the Ownership of Something Increases Our Valuations.

Confirmation and availability bias 

There are many cognitive heuristics we are subject to and if you want a comprehensive list of biases, consider this piece: 10 Cognitive Biases That Distort Your Thinking.

In particular, allow for confirmation bias, when we ignore all information that contradicts us and only consider information that supports our view, and thus become convinced we are right.

Also, take into account availability bias. We tend to be overly influenced by headlines or events that happened nearby or recently. When I was a kid, I was scared a lion might escape from a zoo and attack me. But I didn't feel remotely scared about crossing a road. After 9/11, fewer people flew, and more people drove. The corresponding increase in fatal car accidents exceeded the number of people who died as a direct effect of the terrorist attacks.

Both confirmation and availability bias can make us poor investors — beware of the danger.

Anchoring

Words can influence us, so can numbers.

If we are asked to guess a number, but immediately beforehand we saw a high number somewhere, then our guess is likely to be much higher than if we didn't see that high number. It is bizarre, but true. Daniel Kahneman explains anchoring in this video.

Maybe your investment decisions can be influenced by anchoring, deliberate or unintentional. 

Change your mind 

All of us find it hard to change our mind. I think you can describe the rationale for why we hold a particular view as a network of lots of ideas. But network theory shows that a common type of network known as a small scale network are incredibly robust.  Small scale networks consist of nodes, hubs that are like super connected hubs and super hubs. The internet, social media networks, and the neurons in our brain are all examples of small scale networks. Such networks are incredibly difficult to disrupt. 

The internet was deliberately designed that way, to make it impervious to attack in a nuclear war.

That is just my theory. I have no evidence to support my explanation, but whatever the reason, it is well understood that we find it hard to change our minds.

And investors absolutely must be willing to change their mind.

Are you new to investing? This is one part of a series; catch up with the other parts here:

Beginners guide to investing in shares

Part 2: Risk, volatility and why invest?

Part 3: Five tips for investing

Part 4: Know the product

Part 5: Bubbles, crowd madness & opportunities

Part 6: Disruptive technology


These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees.

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.