Investing is beyond numbers. It also encompasses the market participants – the investors. Behavioral finance analyzes how people affect the figures within the market. Before revealing the psychological traps for investors, let us discuss behavioral finance.

Behavioral Finance

It is a field of finance proposing psychology-based theories to explain stock market anomalies. This study presumes the information structure and characteristics of market participants affect the investors' decisions and market outcomes.

The market is considered efficient. If that is the case, why do bubbles appear? Why do investment techniques fail? Why do strategies such as value averaging work in an efficient market? The answers to these questions boil down to two talking points:

  • Although the market is efficient most of the time, investors' incapacity to see the future leads to periods of confusion; and
  • Market participants avert a perfectly efficient market and worsen the market.


Investing is All About Numbers

To explain the first psychological trap, let us use boxing as an example. Imagine an individual betting on a boxing match and picking out a fighter based on his statistics. A speculator may be right by taking on the fighter with the most number of wins. But the rival might have won his first five fights via knock out.

In investing, figures in the market are insignificant if taken out of context. Numbers-only investors are most prone to panic selling because they tend to hedge their buys with stop-loss orders than their fellows who will endeavor to trigger to generate profit from shorting a stock. These investors believe they need to respond quickly to any change in the numbers to secure profits.

Yes, numbers matter in trading but the company behind a stock is more important. Remember, stocks do not affect the company. The company is. It will not stop its operations just because their stocks decline.

Past = Future

Most investors always assume a stock's previous performance reflects its future, not taking into account the uncertainties in the market. No, that is not the case. Uncertainty never vanishes and it makes trading more exciting, right?

The market is complicated like life. It has its ups and down, overheated stocks, huge losses, bubbles, and panic selling, among others. The belief that past predicts the future is a sign of overconfidence. When many investors hold on to that belief, it shows former Federal Reserve Chair Alan Greenspan's irrational exuberance.

Irrational exuberance refers to a situation in which investors' enthusiasm glides the market up that are not backed by fundamentals, to the extent a huge correction is inevitable. The most affected investors and still there before the correction are really certain the bull run will last forever.

How to be stabbed? It's simple. Trust that a bull will not turn on you.

Narcissistic Bias

This is perhaps one of the biggest mistakes an investor can make. They are so quick in taking credit for portfolio gains, but as fast in blaming other people or outside factors for losses. Doing so helps the investors avoid accountability because they won't take responsibility for the consequences of their investment decisions. Although you may feel better with this feel-good perspective, you are cheating on yourself – and you might miss out a better opportunity to improve yourself and secure best gains. If you have never committed even a single mistake, then why are you trading?

Pseudo-Certainty Effect

It has something to do with investors' perceptions when it comes to risks. They have the tendency to limit their risk exposure if their portfolio's returns are positive and carry more risks if heading for a loss. This is mainly because of the mentality of winning it all back. That should be the other way around. Investors should expose themselves into more risks if their portfolio is doing well because that is a good time to generate more gains. And in times of poor performance, they should limit their risks. Most traders escalate their bets to reclaim capital, but not to create more capital.