Investing money is not just a wise move as a financial precaution, it can also be fun. However, there are plenty of potential missteps. Even experienced investors are not immune to errors. For example, emotions or cognitive biases can cause errors in reasoning that lead to unnecessary risks or to lower returns. In this article, we describe some of the most common investment errors, their psychological causes and how they can be avoided.
Herd mentality
People have a tendency to simply copy what other people are doing, particularly when they are uncertain. This is based on the assumption that the majority must be right, and that moving with the ‘herd’ offers more security. But this is simply not always the case.
- During the dot-com bubble in the late 90s and early 2000s, for example, many people invested in tech shares because “everyone was doing it.” However, many of the much-hyped enterprises did not have a solid business model, which caused serious losses when the bubble popped.
Emotional decisions
In stressful situations, the human brain tends to make quick, and therefore often irrational decisions. These are not based on facts but are instead designed to relieve stress quickly. Emotions such as greed and worry can more often than not lead to the purchase of securities at very high prices, and to selling the same when the price is dropping:
- For example, during the 2008 financial crisis, many investors panicked and sold their shares at a massive loss. Many of those shares, however, had fully recovered after just a few years, and are now once again reaching new peak values. But the investors who panicked no longer own these shares and are thus unable to profit from their renewed value.
Confirmation bias
People seek out information that confirms their convictions. In addition, they interpret new information as confirming these convictions. Information that contradicts their existing opinions, on the other hand, is often ignored or considered less important. If a person only searches for positive information on a company, ignoring reports on its worsening position and financial figures, they will not be able to make a sound investment decision.
Overconfidence
Even people with plenty of experience investing can sometimes overestimate their own skills and knowledge. This can cause them to underestimate risks and place more trust in their own decisions than is warranted.
- For example, they might be convinced that, due to their market expertise, they have selected the best possible investment. So they invest all their money in a single pot. This is a very high-risk strategy, as any business can suddenly experience unexpected financial difficulties or lose ground to a strong competitor. And now the investor is taking serious losses.
Anchoring effect
People tend to be strongly influenced by the starting value (anchor) of a share without adequately taking into account that the situation is continuously changing based on factors such as market conditions and risks. This error is made clear by the following scenario:
- An investor purchases a share for 100 euros. When the price drops to only 70 euros, the investor holds on to the share, waiting for the price to return to 100 euros “to recoup their losses.” However, as they wait, the company’s situation worsens and the price drops significantly once again, to 50 euros.
Too much weight placed on previous developments
Many investors believe that an investment that was successful in the past will continue to grow in value in the future. This is called hindsight bias, in which people believe, after the fact, that they have correctly predicted market developments. This cognitive bias can cause people to assume higher risks than they would otherwise, because they believe they can predict future events. However, this is simply not the case, as shown by the following example:
- In 2020, an investor invests in a fund that has had above-average returns over the past few years. However, the fund now begins to slowly but steadily decrease in value. The earlier profits were based on unique market conditions, so the fund simply cannot replicate its past success.
It is important to think carefully about investment decisions and really take the time to understand them. This is the best way to successfully achieve your financial goals and avoid investment errors. Your bank makes experts available to you who can support you as you make investment decisions that suit your needs. They will provide comprehensive support for your investments, from analysing your situation to implementing individually tailored investment strategies.
With the right mindset and professional help from your bank, you can invest successfully in the stock market and slowly but surely build wealth. Here are some tips to help you get started.
The cognitive biases described here are based on behavioural economic research. You can find additional information in studies such as “Behavioural finance: The Psychology behind Financial Decision-Making” published in the Business Studies Journal (2023).
