Investors behaving badly: are you making these 6 mistakes?

Whether you’re new to investing or a seasoned pro, there are a few common investment traps you are likely to fall into on your investment journey.

Because no matter how rational, logical or detailed we are when researching and making our investment decisions, basic human nature can send us off course occasionally. As French poet Anatole France said more than 100 years ago, “It is human nature to think wisely and act in an absurd fashion”.

Sometimes you win, sometimes you learn…

The good news is – to quote Henry Ford – “The only real mistake is the one from which we learn nothing.”

So, what are the most common investment mistakes, what can we learn from them and how can we avoid them in future?

1. Treating some bits of information as more important than others

Otherwise known as anchoring, this is when we fixate on one piece of information to the detriment of others.

A good example of this could be holding on to the idea that ‘sunny-spells’ on a bank holiday weekend mean a BBQ is a good idea – only to spend the whole time shivering and wishing you were indoors as it’s still only 6 degrees, cloudy and scattered showers have ruined the day.

When it comes to our investments, the danger is, we end up sleepwalking into potential losses. Are any of your investments struggling but you are focusing on the one piece of good news amongst the many bad headlines?

Take a step back and ask yourself: “Forget about the past – would I invest in this company or fund today?” Try to weigh up the pros and cons subjectively.

2. Investing in what is popular

This is when investors ‘follow the crowd’ and choose a particular investment because everyone else seems to be doing so. It plays on our instinctive ‘safety in numbers’ assumption – if other people are buying, it must be a good investment – as well as FOMO – or our Fear Of Missing Out.

However, herd-buying can over-inflate prices and create bubbles, which is bad news for investors when they eventually burst. Just think about the winners and losers who invested in technology in early 2000s or the ‘crypto craze’ twenty years later.

Again, try to look at the fundamentals of an investment and use your own analysis rather than the consensus of the market. And don’t worry about what everyone else is doing – you need to think about whether the investment suits your own personal goals and risk profile.

3. Forming an opinion first, researching second

Doing this leads to confirmation bias. Basically, this is when we hear a ‘hot tip’ from a friend, or perhaps see good three-month return figures, or even just like the branding of a particular fund – and we make up our minds straight away that it is a good investment.

Later, when we ‘research’, we filter information selectively to back up our already-formed opinion and ignore the rest. In this way, investors often overlook facts and crucial details that could significantly affect their returns.

Each time you consider an investment, be prepared to critique and question it, not just confirm your preconceptions. Also, be conscious of what drove past performance. A fund may have had a stellar period, but this could have been driven by a strong market, rather than manager skill.

4. Overreacting to ‘new’ news

A well-known investment adage is ‘buy low, sell high’. In reality, though, it is all too common to see investors buying once things have already gone up and pulling their money out when their investment goes down.

It’s understandable, as these are often important savings and it’s hard to watch their value decline. But it’s also a common overreaction.

Overreaction and availability is when investors treat new news with more weight than older news. Knee-jerk reactions (e.g., sell everything! Markets have fallen 20%!) can lock-in losses that otherwise could have been avoided and lead to severe regret later.

Thinking long-term and avoiding day-to-day market noise is key.

A good way of protecting yourself from this tendency is to consider different scenarios of what could happen before you invest and be braced for volatility and some periods of loss over the life of your investment.

5. Fearing losses more than you value gains

This is referred to as prospect theory. Discounting market noise takes a lot of discipline and isn’t helped by the fact that investors typically fear losses more than they value gains.

Let’s look at an example of two funds over two weeks:

Fund A goes from £1,000 to £2,000 in the first year, but then falls to £1,500 the year after.

Fund B goes from £1,000 to £1,250 in the first year, and then climbs to £1,500 the year after.

Both have the same outcome, but it would be common for investors in Fund A to feel like they had ‘lost out’ because they lost some money from the fund’s peak.

On the other hand, investors in Fund B would typically be happier with their results and more likely to hang on to the fund, as their returns have steadily risen.

Again, the lesson is to think long-term and avoid reacting to short-term sentiment. It’s also important to keep in mind broader market movements. The stock market might have posted large falls over the period, and in fact your fund may have performed better than its peers.

6. Remembering selectively

What doesn’t help with the previous situation is how we typically respond afterward.

In the case of Fund A, for example, a few weeks on, investors often start to say that they knew the drop was coming and kick themselves for not selling sooner.

In reality, they may have had a vague thought their investment could potentially fall, but if they were convinced by that, they would have sold.

When we look back, we typically remember only the thoughts that were prophetic and not the incorrect ones. The problem is, this leads to investors starting to ‘believe their own hype’ and trading on hunches because they have had some correct thoughts in the past. They also tend to rush a subsequent decision without fully researching because they feel they missed out before, and they don’t want to do that again.

How the professionals use behavioural finance

Behavioural finance explores these mistakes and tracks human traits back to instincts developed thousands of years ago, looking at how they affect the psychology of investing (and other financial decision making) today.

If you’d like to learn more about how behavioural finance, a few our Elite Rated managers have discussed the subject in the past.

Steven Andrew, manager of M&G Episode Income, has recorded several video and podcast interviews which touch on the subject. a selection of which are below:

Behavioural finance, investor irrationality and finding opportunity with Steve Andrew

How to benefit from irrational investor behaviour

“Everyone has a plan until they get punched in the mouth”

And, in a very interesting episode of the ‘Investing on the go’ podcast, Morgan Housel, the author of The Psychology of Money, and Mick Dillon, manager of Brown Advisory Global Leaders fund discuss behavioural finance and the psychology of money.

They cover 19-year-old Robinhood investors trading 5,000 a month and why long-term investing is not intuitive to young people, why Baby Boomers are more worried about inflation than Millennials or Generation X and why the fight for an analytical edge in investing is becoming absurd.

This article was first published in February 2016 and edited for republication in December 2017 and May 2023.