Right now, you could be making several dangerous investing mistakes… and you likely don’t even realise it.
You see, stress causes our brains to react with powerful emotions. These unconscious, instinctive reactions can lead to big mistakes – even for the savviest of investors.
What follows are three of the most dangerous investment mistakes that can result in poor decisions… and how to be sure that you don’t make them.
1. The denomination effect
Have you ever had a large bank note, but didn’t want to use it to buy anything? Yet, you had no problem using a bunch of smaller notes to pay for something?
This is known as the denomination effect. Studies have shown that people hesitate to break a $50 note, but don’t mind spending three $10 notes and four $5 notes. When the value of a bank note is smaller, it makes us feel like we are spending less.
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For example, in June 2012, one Apple share cost US$570. For a lot of investors, buying just 20 shares was a big investment. So, even if they could have bought shares, a lot of investors did not touch Apple stock.
(The valuation of a stock – whether it’s expensive or cheap – has nothing to do with the price of a stock. The value of a stock is calculated by looking at a company’s earnings, prospects, cash flow and other factors, and comparing them with the stock price. So, a stock that you can buy for $1 might be expensive, while a $100 stock might be cheap. Price and value aren’t always related).
But attitudes changed when Apple split its shares. Apple’s shares split 7-for-1, so after the split, the stock traded at US$81 per share.
After the split, trading volumes spiked by more than a factor of seven. A lower share price made it easier for more investors to buy the shares – at least psychologically.
Of course, the value of the company didn’t change. The lower share price only meant that investors could now buy in at a lower price. (Of course, if they bought seven or more Apple shares at US$81 (total US$567), it wouldn’t have made a difference if they bought shares before or after the stock splits.)
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One way to deal with the denomination effect is to think like you’re buying the entire business, rather than just shares in it. So don’t just look at the price of a stock, look at its value.
2. Loss aversion
Let’s say that next week you make US$1,000 in the stock market. The following week, you lose US$1,000. Of course, making money is better than losing money. But, is the joy of winning greater than the pain of losing?
Research has shown that for most people, it is not – losing feels worse and our minds experience actual pain when we lose money. The pain we feel from losing is greater than the pleasure we feel from winning an equal amount.
Hating losing more than loving winning causes investors to over-exaggerate risk and play it safe. So, even if the chances of making money are better than losing money, most investors will avoid the opportunity altogether.
Loss aversion can have a negative impact on investors. It often makes investors reluctant to sell when prices fall, even when it’s unlikely that prices will bounce back anytime soon.
So how can you overcome loss aversion?
The Overnight Test is a simple way to avoid making a bad decision because of loss aversion.
Say you invested in a stock that declined in value and are now faced with the decision of whether to sell at a loss, or keep holding it. It’s painful admitting you were wrong, of course. But imagine you went to sleep and overnight the asset was replaced with cash. In the morning, would you now use that cash to buy the stock at the current market price – or invest it somewhere else? If you wouldn’t buy the stock even at this lower price, you should probably sell.
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3. Status quo bias
Every investment, whether it’s stocks, bonds or real estate, fluctuates in value. Prices rise and they fall, and then they do it all again… and again.
Despite this predictability, most investors are caught off guard by these market cycles. A market was moving in one direction, and then the cycle moves on to the next phase – leaving everyone surprised. It’s such a surprise because of status quo bias.
That means we tend to think things are likely to remain the same – because our most recent memory is of them being a certain way. Investors buy a stock that’s been steadily rising in price because they expect it to continue going up.
Investors fall victim to status quo bias because they believe the four most dangerous words in investing: “This time it’s different.”
Of course, nothing is different. The cycle always prevails, the bubble bursts and prices fall.
The best way to beat status quo bias is to procrastinate.
Behavioural economics studies have shown that if asked to make a particular decision about something by the end of the day, people are more likely to decide to leave things unchanged. Change is hard and the status quo is easy. And, when you don’t give yourself time to make a decision, it’s easier to keep things the same.
But, when people are asked to make a decision by the end of the week, they’re more likely to think carefully – and decide based on facts rather than the comfort of the status quo. That suggests change comes more easily if you have time to get used to it.
So the next time you think that this time is different, wait a bit. You may realise that, in fact, it isn’t different and almost never is. That can be difficult to accept when markets are going up, but it’s a relief when they’re headed down.
To sum up, we all have emotional responses we don’t fully recognise when it comes to investing our money. Even the savviest investors sometimes give in to their emotions. So before you make another investment, stop and make sure your emotions aren’t costing you money.
Publisher, Stansberry Pacific Research