The small 1 x 1 of stock market psychology: Why investors usually do not act rationally
Economic experts have observed the behaviour of investors and gained exciting insights. Your behaviour when investing money says a lot about your probability of success. In this blog post, we want to draw your attention to the biggest psychological traps. Afterwards, we will of course show you how to do it right and how you can trick the stock market.
Probably the most important observation shows that investors usually lag the market. In other words, they buy their investments when the market has been doing well for some time and the securities are expensive. And then they sell them again when the investments have already lost a lot of their value. The chart below illustrates the investor’s rollercoaster ride.
Let’s go through the example here (with investor Maria Muster): The market is behaving well and prices are rising. Maria speculates that prices will continue to rise and therefore does not want to miss the “possible” upswing and continues to purchase. Maybe this strategy works for a while. At some point, however, it changes again and prices fall. The investor may remain calm for a short time and hope that the market will recover. But as soon as the pain threshold is reached, panic sets in. Maria now assumes that prices will continue to fall and does not want to incur even more losses. Therefore, she sells her investments at a much lower price. In case the value of the investments continues to fall, Maria is relieved for a short moment and perhaps glad that she sold “in time”.
But as soon as the markets recover, which is always the case sooner or later, she misses the next upswing. But for fear of further possible price losses, Maria is still waiting. After all, she doesn’t want to make the same mistake again. There is a good chance that one will only buy again when the prices have recovered and prices have risen again.
But for Maria, the investor, this means that she again buys too expensively. Maria and many other investors lose twice in this game. Once when they buy too expensive and a second time when they sell too cheap. With all these purchases and sales, in addition to the price losses, there are also transaction fees.
Such a rollercoaster ride can happen for two reasons.
- The investor has speculated on short-term fluctuations. He or she has tried to “time” the market. “Market Timing” or speculating on price developments does not work in most cases, as one always lags behind the price developments.
- Inexperienced investors are more influenced by price fluctuations. They panic more quickly and thus sell their investments at unfavourable times and at a lower price.
There is no need to get nervous because of short-term fluctuations, as the markets have recovered in the long term after every crisis. As can be clearly seen here in the performance of the Swiss stock market.
In addition to trying to find the right time, investors often make the mistake of trying to pick the “right” stocks. Stock picking does not work well in practice. Investors purchase securities that promise a high return. They focus on individual stocks of certain companies in very specific sectors. Perhaps investors have heard or read about a certain security in the media. However, at this point in time, this security is usually already overpriced. The investor focuses on securities that are currently in vogue. There is a danger of insufficient diversification. This can lead to further problems, such as cluster risk or an uneven risk-return ratio. With insufficient or even no diversification, a poor market performance in one industry, country or individual company can completely wipe out the total return of a portfolio.
With the investment solutions from findependent, you are invested in over 3’000 individual securities in different sectors, countries and regions. This ensures that you are sufficiently diversified.
Over- and underreactions
Another interesting finding is the reaction to megatrends or megacrashes: investors tend to underreact to megatrends such as America’s debt or climate change. However, they tend to overreact to mega-crashes such as the Corona crisis or bank failures abroad. An overreaction means, for example, that they sell their investments in difficult stock market times out of uncertainty that prices will continue to fall.
Investors like to distinguish between paper losses and realised/actual losses. Paper losses here mean a potential loss that could occur if one actually sells one’s investments (at a low price). The name paper loss comes from the fact that the loss only occurred on paper.
Studies have shown that investors like to turn paper profits into real profits, but do not want to turn paper losses into real losses. The result is that in the end there are only “loser equities” in the portfolio, since the “winner equities” were sold in order to actually realise the profit. Losses and profits are therefore not treated equally. Another exciting finding on the side: profits and losses are also treated unequally “in terms of value”. A loss of 100 Swiss francs causes a much stronger reaction than a profit of the same amount, even though the two amounts are the same.
With access to current market data and the ability to make adjustments at any time, investors tend to do more than is necessary. They can observe market fluctuations live and they are therefore tempted to take action as soon as prices fall. They can adjust their investment solution within seconds, as well as make purchases and sales, and usually quite simply via an app. The fact that they have access to everything at all times gives them a certain illusion of control, and this illusion of control awakens in them the need to use this control.
However, access also conceals its dangers. One is tempted to actively adjust the investment solution or the personal deposit behaviour and thus commit the mistake of “market timing”.
Emotion and intuition
Emotions should not play a role in investing, but it is difficult to ignore them. Price gains bring pride, while losses bring frustration and sadness. Emotions are counter-intuitive, especially in the face of prolonged losses. Losses lead to stronger negative emotions and these in turn stimulate the investor’s trading activity. You may have noticed that you only read and hear about successful investors in the media. Because nobody likes to talk about their losses.
The same pattern plays out with intuition or gut feeling. It is hopefully clear to everyone that gut instinct is a bad advisor when investing. However, it’s hard to ignore that gut feeling when your investments are losing value and your gut is telling you, “You have to do something about it!”
A final point we would like to address is the herd behaviour that investors exhibit, especially in times of crisis. Here, too, several reasons play a role. The starting point for such a phenomenon is falling prices. As shown above on our “roller coaster” picture, we tend to sell when prices are low. As more and more investors sell their securities, prices continue to fall and such signals further unsettle investors and the vicious circle continues. At the end of the spiral, the securities are worthless.
How do I avoid these thinking errors?
Now that we’ve covered some of the biggest mistakes in investing, in the next section we’ll show you how to avoid them and what behaviour will make you a successful investor.
The magic formula for successful investing is simple and consists of only three steps:
- diversify widely
- invest for the long term
- implement inexpensively
Broad diversification protects you from risks in bad times. If the securities of certain companies lose value, thanks to a broadly diversified investment strategy you still have enough other securities in your portfolio to make up for these losses. One way to be broadly invested at the lowest possible cost is through ETFs..
What is an ETF?
An Exchange Traded Fund, or ETF for short, is an exchange-traded fund that tracks an index, such as the Swiss Performance Index (SPI).
Many different companies are represented in an index, in the example of the SPI it is almost all Swiss public limited companies listed on the stock exchange.
Thus, with the purchase of an ETF, your money is invested in a diversified way. Diversification is one of the most important principles when investing. This protects you from unnecessary risks. If you were to purchase a single equities and that company went bankrupt, you would lose all your invested capital. It is almost certain that all the companies in an index will go bankrupt, rendering the ETF worthless.
There are two options for income in the form of dividends (for equities) and interest income (for bonds): distribution or reinvestment. The latter is also called reinvestment. Instead of paying out the income to your account, it remains invested in the ETF.
- Distributing ETFs pay out interest and dividends
- Accumulating ETFs reinvest the income
The second step says that you should invest for the long term. Of course, long-term can mean something completely different depending on the situation. In connection with the topic of investing money, we would like to advise you to only invest money that you can spare in the next 5 to 10 years. And you should also stay invested for at least that long, if not longer. With a long investment horizon, you benefit more from the compound interest effect.
The final step is to implement your investment portfolio cheaply. The most affordable way to do this is through an online asset manager, such as findependent. At findependent you only pay 0.44% management and custody fees.
All of the above steps only work if you stay consistent and go with the short-term fluctuations. Even if your gut tells you to do something else.
The most successful investors stick to their risk appetite, deposit regularly and automate their investments as much as possible.
The advantages of this strategy, which may seem “boring” at first glance, are as follows:
- For example, by always depositing a fixed amount at the end of the month, you are not tempted to engage in market timingmarket timing. No matter what the prices look like at the moment, you stay true to your strategy. With a standing order for your deposits, you reduce the risk of speculating.
- Thanks to your investments in ETFs, you are broadly and cost-effectively diversified. With just a few ETFs you can track the entire global economy without having to purchase individual (expensive) securities. With a single ETF, you can easily map entire sectors, countries and regions without having to engage in stock picking.
- It is not necessary to try to incorporate the latest stock market news into your portfolio. Try to leave emotions out of it and don’t get into a compulsion to control. It is not necessary to check the stock market prices every 3 minutes. This only costs you unnecessary time and nerves.
- At findependent, we focus on long-term market growth instead of short-term trends. This is more sustainable and more promising.
Investing money involves many sources of error. In this blog post, we looked at the biggest investment pitfalls. We also showed you how to avoid them. We know how difficult it is to stay calm when prices continue to fall. Nevertheless, this is the only correct solution. Not only we, but thousands of investment professionals before us have already found this out. In conclusion, there is only one thing left to say: stay calm and stay invested, because the next upswing is sure to come!