Self-directed investors set themselves a significant challenge, but ironically most take little account of the one thing most likely to scupper their efforts: being human. Self-directed investing may look easy, but the reality is that many investors will make some very painful – and expensive – mistakes. Even more depressingly, many will find themselves making the same investment errors again and again, until at long last they finally call a professional investment manager in.
DIY investors face quite a task, but perhaps the biggest challenge of all is circumventing human nature. The desire for more, the fear of missing out and the unfortunate tendency to compare oneself to others are near-universal traits. Succumbing to these influences as an investor can be disastrous.
As any economist will tell you, markets are not rational; nor are people. Investing is undertaken by human beings who invest at the mercy of their emotions. While people are generally adept at analysing data, they tend to be less good at withstanding the influences of psychology. So, while people may reach similar conclusions from their analyses, what happens next varies wildly. We are at the mercy of a range of psychological factors which can lead even the most disciplined among us to make serious errors of judgement when investing. Along with their investment expertise, professional wealth managers can be objective in a way most lay investors simply can’t.
Unpicking the psychology of investment
The psychology of investment contains many separate elements – all of which can lead to poor investment decisions.
The first force to consider is greed. Greed is a powerful characteristic, which usually enables an individual to ignore caution, logic, risk aversion and prudence – not to mention the memory of painful past experiences and a host of other sensible behaviours that should in theory keep investors out of trouble. Instead, greed can lead people to pursue investment strategies that they hope will deliver high returns, without high risk. People will pay often pay inflated prices for investments that are in fashion, hoping for further appreciation; just as often they are then left surveying their errors of judgement in the rear-view mirror of hindsight as the investments decline in value.
Next comes fear. Fear and greed make a powerful combination. Fear prevents investors from making constructive investment decisions when they should.
Typically when a market has reached extremes, fear is the force that stops a person from investing at the bottom of a market cycle or taking profit at the top – the seemingly obvious way to make money.
Hope springs eternal, usually over logic.
This leads nicely into the tendency for people to dismiss logic. Logical decision-making should form the cornerstone of an investor’s thought process. The purpose of investing is to make serious decisions (and of course returns) and be on the lookout for things that might trip us up. Inadequate scepticism leads us to make poor decisions and ultimately lose capital. The classic post-mortem of financial catastrophes often include the phrases “It was too good to be true” and “What were they thinking?” What exactly makes investors fall for these delusions usually equates to them ignoring the lessons of the past. When similar circumstances occur again after a few years they are trumpeted by a fresher generation of investors extolling the wonders of this a new “infallible” investment. Hope springs eternal, usually over logic.
Next up on the list of contributors to investment error is following the herd. Human beings exhibit a common tendency to feel safe in groups, and nowhere is this more evident than in investment behaviour. The pressure on individuals to conform and the desire to get rich usually allows the unwary to drop their guard and join the latest fad or investment bandwagon. Indeed, those that do not initially share the consensus view often begin to feel left out and are eventually unable to resist the urge to join the rest. Think back to the tech bubble where some investors made a fortune and many more lost almost everything.
Envy is the next psychological contributor. However negative the force of greed is, the impact is strongest when people compare themselves to others. Generally in life, and very often when it comes to investing, people become disillusioned and unhappy at the thought that others might be doing better and making more money than they are. If you managed to make a 6% return – which is no bad thing – and your friend made 12% don’t let yourself be influenced by the destructive power of envy. You might do better than your friend next year.
The final major psychological influence is ego. Achieving solid returns in good years and suffering smaller losses in bad ones is a sound investment philosophy, if one which won’t stir the blood. Those investing without ego will invest without exhibiting risky behaviour and be cognisant of how much they don’t know whilst keeping their egos in check. Although this isn’t a glamorous path to follow, it does demonstrate a prudent and logical approach. Investing shouldn’t really be about an adrenaline rush when your financial future is at stake.
Summary
Human beings are sensible and logical beings with the ability to make solid decisions – in most situations. Unfortunately, when it comes to investments things can take a nasty turn due to the negative influences outlined above. Investors hold onto convictions for as long as they can but when the psychological and economic pressures become too great, they jump on the bandwagon headed down Poor Street.
Remember that to be a successful DIY investor one has to be disciplined. If you’ve tried and failed, you’re not alone. In fact, one could say: you’re only human.
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