Investment Traps and How to Avoid Them – Investing money is a great way to grow wealth, especially over a long period. But if you’re new to investing it’s easy to fall victim to certain pitfalls that could set you back financially. There are two types of investment traps, that is cognitive and emotional, but they’re generally termed behavioral biases.
A bias is mostly an unconscious predisposition to think or behave a certain way, in a given situation. It’s easy for investors to get trapped in them because investing always involves incomplete information and a range of probabilities. There are many aspects of investing that are out of our control. Sure, we can hope for a certain outcome, but it can never be guaranteed. So biases are simply the shortcuts we use to make investment decisions.
7 Deadly Investment Traps and How to Avoid Them
1. Anchoring trap
Anchoring refers to an over-reliance on what one originally thought. It involves holding on to the idea of the initial value of an asset to an extent that causes a person to make wrong decisions. For example, you might be under the impression that a certain company is successful and think that buying stocks in it is a good way to go. However, this concept may be inaccurate at present or some point in the future. The same is seen when an investor holds onto a stock for too long because they’re anchoring on the higher price than the stock was purchased for when in a real sense the stock should have been sold a long time ago.
For one to avoid this trap you need to have an open mind and be receptive to new sources of information and understand that just cause a company is doing great today it doesn’t necessarily mean they’ll still be on top tomorrow. Studies have shown that some factors can mitigate anchoring, but it’s hard to avoid it altogether, even when people are made aware of the bias and deliberately try to avoid it.
But in any case, keep in mind that the future performance of an investment is never guaranteed. Just cause a stock did well the last time doesn’t mean the same will happen next time. Do some digging and find out the price history of the asset to help you understand how it will likely perform going forward. Be open to new investment info even if it may not perfectly reflect what you learned about the stock initially.
2. Sunk cost trap
This involves protecting the decisions or choices you made in the past which are often harmful to your investments. This is brought about by not truly accepting that you made the wrong choice that resulted in losses. You can also say it’s the tendency of a person to follow through with something that doesn’t meet their expectations mainly because they’ve already invested their time or money. This explains why people tend to keep clothes they hardly wear, finish meals that don’t taste good and sit through movies they don’t like till the end. And also why they hold on to underperforming investments.
This is similar to anchoring and involves individuals who hold onto stocks with hopes that the price will return to where it was at first. In this case, the investor is protecting their decision to buy and hold that particular stock which can negatively affect their portfolio. If your investment isn’t going great or is sinking rapidly, the best advice would be to abandon ship sooner rather than later and look for something more promising.
As hard as it can be, you need to accept the loss or the fact that you made a poor decision. If your investment doesn’t go as planned, move on before the price of the assets goes down even more. Word of advice. Avoid any emotional ties to your investments to make things easier to unload before things become even worse. The best way to avoid this trap is to set investment goals.
Investors could set performance targets on their portfolios and if these goals fail they could be re-evaluated to see where improvements can be made to achieve better returns.
3. Pseudo-certainty trap
The term also known as loss aversion describes an investor’s view on risk. When investors think that their investment returns will be positive they limit their risk exposure, however, when they’re heading for a loss, they will reach out more and take more risks. They are willing to raise the stakes to reclaim capital but not to create more capital.
Loss aversion may be involved when the thought of losing money overshadows any potential to gain money with an investment. It usually occurs when an investor isn’t willing to take risks to not suffer any losses. Of course, there’s always risk involved in investments and some are riskier than others. When loss aversion comes in, you miss out on the potential to make profits because you’re worried about losing your investment capital.
No doubt that taking on too much risk is a recipe for disaster but so is not taking enough.
Come up with a sound investment strategy and don’t let your emotions affect your decisions. Allow yourself to get a little uncomfortable. Make calculated decisions about where to invest by choosing assets that have a good track record.
4. Superiority trap
Otherwise known as the overconfidence trap. Many investors are overconfident and think that they know more than the experts themselves and even the market. Being well educated doesn’t mean you can’t benefit from a few tips here and there. A lot of investors have lost huge amounts of money by thinking that they’re better than everyone else and these are mostly the same people who fall into a number of the investment traps aforementioned.
Investors trapped in the superior state of mind have inflated views of themselves. They are overly confident in their investments and capabilities and as a result, may even reject good advice that could lead to errors in their judgment.
An investor may become reckless and fall into a losing position backed by the assumption that he or she knows better than the market. The investor is optimistic that eventually the market will see the stock’s value proposition and push it higher. But if the stock continues to decline, the investor chooses to cut losses and close the position. If you’re overly confident with the investments you’re making, you may fail to put in place the safeguards needed to protect your investment capital. You might make poor decisions and end up risking too much which can only result in losses.
This stands for Fear Of Missing out. This is closely related to following the sheep behavior since it causes people to follow what others are doing without thinking things through. Sheep mentality refers to the tendency of an individual, in this case, investors, to follow and copy what other investors are doing. They are largely influenced by instinct and emotion instead of their independent analysis. Investors follow other investors probably because they see them succeeding instead of making their own informed decisions about where they’d like to invest.
Investors who fall into this trap usually fear that they’re missing out on a potentially lucrative investment when they see their friends or someone close to them investing heavily in it. So instead of feeling left out, they feel much better and more at ease when following the herd. Many dot-com companies for example didn’t have financially sound business models, but many investors bought into them solely because other people were buying into them.
Following the crowd seems to be a way investors think they’re making the correct decisions. So if everyone is folding out of the market they feel safe doing the same as opposed to being the only ones left behind. Don’t be in a hurry to do what others are doing without doing your research. Assess the investment carefully and review the company’s fundamentals before deciding whether or not it’s worth investing in.
6. Irrational exuberance trap
Irrational exuberance also referred to as overconfidence bias is a tendency to hold a false and misleading assessment of our skills and intellect. In short, it’s the belief that one is better than one is. While confidence is believed to be a strength in many scenarios when it comes to investing it’s more of a weakness. Investors tend to think that the past equals the future as if there isn’t uncertainty in the market.
What happened before will surely happen again. There will always be ups and downs something that will turn tables on investments that were once on top. There’s often the case where investor overconfidence turns to greed and pumps the market to a point where a huge correction is inevitable.
And the ones who are greatly affected are the ones who went all in just before everything went south, the overconfident ones who think the well will never run dry. If you’re new to the world of investing, think about working with someone with experience who can come up with a sound investment strategy that can maximize profits while avoiding too much risk. You don’t have to rely on yourself alone as there are many experts to help you along the way.
7. Confirmation trap
A confirmation trap occurs when people look for and take notice of other investors or assets that confirm their current beliefs. It may also occur when investors continue to get advice from others who have made and continue to make the same mistakes. Sometimes people seek out advice from these people who are hoping to make the right decision this time around. Instead of listening to someone who gave you bad advice, reach out to fresh sources who will give you sound advice on potential places to invest.
When researching an investment, investors may inadvertently look for or be in favor of information that supports their preconceived notions about the asset or strategy and fail to acknowledge information that contradicts their ideas.
This forms a one-sided view and causes investors to make poor decisions. Confirmation bias is a source of overconfidence on the part of the investor and helps explain why they don’t always act rationally and perhaps supports arguments that the market behaves inefficiently. The first step towards overcoming confirmation bias would be to know that it exists. After gathering information that supports their beliefs and opinion, they should seek alternative views that challenge their perception.
In short have an open mind. Investing indeed comes with risk but you may be even more vulnerable if you find yourself caught in one of these investment traps. Do your research beforehand and find out what works for you.
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