Your brain on money: common traps
The biggest risk to your investments is often the person in the mirror.
Fear and greed
FOMO (fear of missing out) is the urge to pile in after something has already shot up, because everyone else seems to be getting rich. It often leads people to buy near the top.
Panic selling is the opposite: selling after a big drop to make the pain stop. It locks in losses and often means missing the recovery. Together, these lead to buying high and selling low, the reverse of what investors want.
Overconfidence
After a few wins, it's easy to feel like an expert. Overconfidence leads people to trade too often, bet too much on single ideas and underestimate risk. Frequent trading also adds costs and, in taxable accounts, taxes. Luck in a rising market can feel exactly like skill.
Home bias and other blind spots
Home bias is holding mostly investments from your own country, or even your own employer, because they feel familiar. The US is a large part of the world stock market, but far from all of it, and for investors in smaller countries, home bias can mean very concentrated risk. Holding lots of your employer's stock is double exposure: your job and your savings depend on the same company.
Other common traps: anchoring (fixating on the price you paid) and loss aversion (research suggests a loss can feel about twice as painful as an equal gain feels good, so people hold losers too long hoping to break even).
Jordan buys $5,000 of a hot stock after it doubled, at $100 a share: 50 shares.
It falls 40% to $60. Jordan panics and sells: 50 x $60 = $3,000, a $2,000 loss.
A year later it's back at $90. Holding would have meant a $500 paper loss instead of a $2,000 realised one. The price path was the same; the behaviour made the difference. (Of course, some stocks never recover, which is another reason to diversify.)
Key terms
- FOMO
- Fear of missing out: the urge to buy something because others are profiting from it.
- Panic selling
- Selling investments in fear after a drop, often locking in losses.
- Overconfidence
- Overestimating your own skill or knowledge, often after a few wins.
- Home bias
- Favouring investments from your own country or employer because they feel familiar.
Have a plan before emotions show up, and stick to it when they do.