Behavioural investing traps to avoid when share picking and trading

The ruckus over GameStop offered some new lessons for investors, including the phenomenon of an ‘angry’ bubble rather than one motivated by simple greed.

The rise of free trading apps and the role of social media communities were also critical to understanding the staggering rise and fall in the share price of an obscure games retailer. 

Meanwhile, just when the investing world thought that the story had been put to bed, GameStop shares posted another bumper rise – doubling in trading on Wednesday 24 February.  

But while elements of the GameStop story were new, traders also fell into some classic behavioural investing traps, easily recognisable to experienced stock investors, most obviously that of ‘herding’.

This is where people draw comfort and reassurance from doing the same as everyone else in pursuit of a popular investing trend.

More investors join in because they see others making money, and that encourages yet more people to get caught up in the rush, from fear of missing out.

Behavioural investing looks at the ways people risking their money often fall into psychological traps.

There are many others besides herding it pays to keep in mind when choosing, buying, selling and holding stocks.

Understanding these traps can offer insight into whether your investment judgment is sound or if you are just making excuses to yourself for irrational decisions.

Jessica Exton, behavioural scientist at Dutch bank ING, says: ‘To understand markets we need to understand what drives behaviour.

‘People aren’t naturally designed to be effective long-term investors. We focus on what’s happening right now, hate to lose and interpret information in different ways.

‘Herd behaviour and reactionary decision-making can result.’

Exton and Tom Stevenson, of Fidelity International, highlight 10 traps to beware of when investing in stocks.

1. Frequent viewing

‘If watching the value of your stocks fluctuate makes you uncomfortable you aren’t alone,’ says Exton. ‘This is a natural reaction.’

Jessica Exton:  We feel the pain of a loss more than the joy of an equivalent gain

She says that if you have set achievable and specific goals and are investing to make a return over the longer-term, it is best to resist the urge to check your investment portfolio often.

This will help you avoid panicking about short term changes.

She adds that instead of checking up frantically, you should: ‘Set periodic reminders to check your stocks so you can keep an eye on them, and then let them be.’

2. Quick reactions

‘We like to feel in control and often feel more in control when we take action,’ says Exton. ‘

We also feel the pain of a loss more than the joy of an equivalent gain.’

She warns that if the value of an investment decreases it can be tempting to make a change quickly, even if this doesn’t pay off in the long run.

‘It can help to consider your longer-term investment goals before acting.’

3. Blissful ignorance

Exton says that while you can never know for sure what will happen in the future, you can educate yourself to make informed decisions.

‘When a transaction takes place, the seller no longer believes the stock is worth holding, while the buyer believes just the opposite. Both expect to make a return, having interpreted the market in different ways,’ she points out.

4. Becoming more optimistic as markets rise

Tom Stevenson:  As soon as you own something it becomes more valuable to you than could objectively be the case

You can look to two famous fund managers for wisdom on this trap, according to Tom Stevenson, investment director for personal investing at Fidelity International.

Former star manager Anthony Bolton, who has now retired, used to tell young colleagues to try to become more optimistic as markets fall, says Stevenson.

Tom says: ‘Obviously this is very difficult because it requires you to swim against the tide. To be greedy when others are becoming fearful, to use Warren Buffett’s phrase.’

5. Falling in love with what you own

Becoming emotionally attached to things you have bought is a behavioural investing trap also known as the endowment effect.

Stevenson says: ‘This is most obvious in the housing market but applies to stock market investors too.

‘As soon as you own something it becomes more valuable to you than could objectively be the case.

‘It is why houses are often taken off the market unsold; their owners simply cannot accept what the market is telling them.’

6. Confirmation bias

This is the tendency to believe whatever confirms an existing opinion and disregarding anything that contradicts it, which is unwise when you are making investment decisions.

Instead of giving in to this bias, you can make a practice of analysing the reasons against making an investment, as well as those in favour.

Stevenson points out we are all prone to seeing what we want to see in all areas of our lives.

Reading articles that confirm our prejudices and refusing to listen to those with whom we disagree are common examples, he says.

Stevenson warns investors that social media encourages confirmation bias because its algorithms serve up what the platforms think we will want to consume.

‘I read both the New Statesman and the Economist each week if I can, to force myself to see different sides of an argument,’ he reveals.

7. Cutting profits and running losses

We should do the opposite of the above, says Stevenson.

‘It is easy to be tempted into grabbing a 20 per cent profit but pretty much all the stock market’s total gains over time are delivered by the handful of companies that grow and grow year in year out.’

He adds that running losses is not quite as damaging, but that usually a decisive move to cut a loss and move onto something better is the best approach.

8. Over-confidence

When it comes to investing, people have a tendency to be confident they can predict the future, yet forecasts of anything from company earnings to inflation or economic growth tend to be wrong.

Over-confidence offers people the illusion of control, says Stevenson, but he cautions: ‘The majority of people think they are better than average at most things.

‘By definition they cannot be. Two things definitely are true. Wait long enough and our performance will gravitate to the mean, and the future is uncertain.

‘Put those two together and the best defence is diversification.’ 

9. Overpaying for growth

This is otherwise known as falling in love with the story. Some behavioral investing experts also warn against a ‘winner’s curse’, which means overpaying for what is believed to be a winning investment.

‘Everyone knows that Apple, Google and the like are great businesses, says Stevenson. ‘What many investors forget is that the story of a stock is only half of it.

‘The price you pay is crucial to determining investment success. A good story at a reasonable price may turn out to be better than a great story at an over-optimistic price.’

10. Timing the market

This is a common error, especially among rookie investors, although professionals also have a bad record at calling the top and bottom of the market.

The usual defences against bad timing are investing for the long term and drip feeding cash into investments, so you benefit from the highs and mitigate the impact of the lows.

Stevenson says you need to make two decisions if you try to time the market.

‘If you sell out, you need to buy back in again. The success of your first decision can make the second even more difficult.’