How to overcome your psyche and become a successful investor?

Let’s explore the most common natural traits of our psyche leading us to investment losses. We’ll also discuss how to confront them so that we don’t repeat the mistakes of unsuccessful investors from the past.

Herd Behavior

In the 17th century, wealthy merchants and nobles in the Netherlands were buying tulips for the same price as furnished houses. Their worth wasn’t based on rarity, growing demands, or breeding potential. It was based on the aristocracy's willingness to pay high sums. Three centuries have passed since then, but similar stories can still be found in today’s world.

At times, the value of certain stocks rises sharply. Few maintain this for the long term, but most will sooner or later collapse. For example, Microvision was a relevant company in the 90s, which eventually began to decline to the point where it risked being delisted from NASDAQ.

In these situations, however, investors hear from all sides—whether from their daily lives or social networks—about the returns these investments offer. They look at the rising value graph and are lured by the illusion of quick and high profits.

It gets to us too. Friends want to show off their quick gains, influencers present once-in-a-lifetime opportunities, and the media report on wealthy investors who have also decided to buy many stocks. Of course, they "forget" to mention how many times their tip for getting rich has failed.

Naturally, we fear that if we don’t jump on this opportunity, everyone around us will get rich, and we’ll miss the train (known as "Fear of Missing Out" or "F.O.M.O."). So, we don’t consider whether we really understand the investment or whether the company is worth it. We invest in it simply because everyone else is doing it.

This behaviour mirrors that of a herd of animals moving in the same direction. Each animal is confident that the one ahead knows the path and destination, and that’s why it doesn’t need to think about whether it's heading in the right direction.

People don’t rush after one another on the street, but they still make similar mistakes - accepting the majority's opinion and following it every step of the way, instead of focusing on facts. Think of the cliché your parents probably told you: “If your friends jumped off a bridge, would you jump too?”

Confirmation Bias

An investor begins to select facts that support their overall view. This is a bias that shows up in small ways, and we don’t even notice it. For example, instead of being skeptical about rapidly rising stocks and questioning their rationality with thoughts like “everyone’s jumping on board, what if it’s unjustified?”, we ask ourselves “everyone is buying it, why is it so good?”

We set out on a path of finding facts that show why the actions of others are correct. Along the way, we keep confirming the emerging, but often misleading, narrative.

Only a few employed people with families who can afford to spend long hours researching the pros and cons of the market. And if we add to that the prospect of quick wealth, who would deliberately spend a lot of time searching for facts that crush their dreams?

With each new piece of information that argues against our belief, we lose stability or our confidence in the initial judgment we formed so confidently. When we lose stability or self-confidence, we don’t feel comfortable. However, it’s even more uncomfortable to lose the money we’ve invested.

Overconfidence

We’ve already confirmed our assumptions and invested. After a short profit from the bubble, we feel we can predict the market and forget about the risk. Some investors then invest nearly all their money into one market (in the worst case, into one stock or cryptocurrency) and ignore the need for diversification.

The higher the prices rise, the more money they invest. During the dot-com bubble, investors made only “small change” on traditional markets as opposed to the emerging internet companies. That meant one thing to them – unused capital. Many of them got rid of the stocks that had stabilized their portfolio and focused solely on quick profit from internet companies.

The Bubble Bursts

Eventually, some investors realize that stock prices are unsustainable and excessive. This happened with tulips in the 17th century, the dot-com bubble during the internet boom when even loss-making companies were rising, and the housing bubble in 2008 when families couldn’t afford housing.

Today, we’re still making the same mistakes, such as the infamous GameStop or MicroVision cases. When investors realize that the market is inflated, they begin selling and trigger a domino effect. They rush behind each other like a herd. Want to know what happens after that?

The market renews itself and returns to its original values, with stocks reflecting the actual success of the issuer, their profits, market, cash flow, debt, and other measurable factors. And what happens to the money of hopeful and success-blinded investors? They mostly lose it.

Investor willingness to invest increases in proportion to rising stocks, so the later the bubble bursts, the more they lose. By 2002, after the dot-com bubble burst, 100 million investors had collectively lost around $5 trillion. In today’s money, that’s nearly €80,000 per investor.

Fear of Loss Wins Over the Possibility of Gain

The bubble burst, investors realized the overvaluation of stocks, and they jumped off the sinking ship to minimize losses. The market went through a correction, and prices dropped. In such cases, a falling market (known as a "bear market") dominates, and investors lose hope for growth.

But is this chaos justified? If you have a long-term strategy, it’s not. Think back to the crisis brought on by the COVID-19 pandemic. Global trade slowed down, and purchasing willingness fell. Investors got scared and started behaving as usual.

At the beginning of 2020, the value of the S&P 500 index fell by a third. However, in the following months, stocks recovered and returned to growth. From the pandemic's low point, this index is up by 150%. Considering how bad it initially looked, it’s a decent recovery.

Why do we rush to sell our stocks at every inconvenience? It’s driven by loss aversion. A portfolio drop and crisis news may convince us that our money is slipping away from our wallet, even though it’s often just a temporary state.

Even if your deposit isn’t in the red, a drop in stocks you’ve been profiting from can unsettle you. You get scared that something is wrong with your investment and quickly get rid of it.

You’re not alone in this. Even the most experienced investors experience numerous stock downturns throughout their lives. On average, they experience a 10% drop every 1.5 years, and a 20% drop every 4 years.

How do they deal with this? They diversify and invest in entire markets, such as ETFs. The collapse of an entire market has only happened a few times in human history, while the failure of companies to zero is something we experience constantly.

How to Avoid Our Irrational Mistakes?

Even though we’re irrational beings and often make mistakes, there are methods to minimize the impact of our emotions. So what are they?

• Don’t speculate or chase investments (stocks, cryptocurrencies) just because they’ve risen sharply in recent months or because they’ve been recommended by influencers and friends.
• Diversify your investments so they cover most global regions and economic sectors. If you put most of your money into one sector or company, you risk losing a significant portion.
• Make a plan – what do you want to achieve through investing and how long do you plan to invest? Then set the level of risk suitable for that goal. Our robo-advisor can help you choose the right strategy.
• If you’re diversifying across the entire market, remember that declines are a normal part of investing. On average, drops of 10-20% happen every few years, so you’re bound to experience them during a lifetime of investing. Don’t panic, wait for recovery (or take advantage of the dip to buy shares for lower prices).

At Finax, our strategy is clear and simple: we invest long term. Diversifying your portfolio properly so that you are confident and willing to invest with it for the long term is not easy. Some investors predict their investment incorrectly, get scared of its decline and sell it off at a loss. Others set their investment too conservatively and miss out on profits.

That's why we offer fair and objective suggestions through robo-advisors, which tailor your portfolio based on a questionnaire you fill out. You simply answer questions about your intended investment duration, investment experience or your financial situation and our robo-advisor will recommend a diversified portfolio suitable for your situation. In doing so, it will make decisions based on long-term market data, not emotion, greed or fear.

If you have a well-configured portfolio, have diversified your investments across multiple markets, and are investing for longer periods of time, you've done everything you can to become one of the smart investors.

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