Common investment pitfalls

Investing can be hugely rewarding. But we need to be able to navigate behavioural tendencies that may cause poor investing decisions.

Taking control of your own finances can be hugely rewarding. But it is also permeated with investing mine traps that could potentially derail your returns. 

Even seasoned investors and professional portfolio managers are not immune to these pitfalls.

Many of these are innate behavioural human tendencies that create delusions and lead to investment errors.

Jason Zweig, the author of the best selling book, Your Money and Your Brain, said, "Humankind evolved to seek rewards and avoid risks, but not to invest wisely. To do that. You'll have to outwit your impulses - especially the greedy and fearful ones."

With that said, here are three common human tendencies that may impact our investing.

MAKING GROSS GENERALISATIONS 

The human brain makes sense of the world by recognising patterns. But when it comes to investing, assuming a pattern when there really isn't one could be detrimental.

Carolyn Gowen, a well-respected financial advisor, recently wrote in her blog that "in investing, we often mistake random noise for what appears to be a non-random sequence."

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To lower the chance that we mistake a random sequence for a pattern, we should look for real economic reasons behind a correlation.

Second, never rely on short-term data. Investing should be viewed in decades, rather than months or years.

HERD MENTALITY 

Humans are social creatures. We want to be included and accepted. It is, therefore, not surprising that herd instinct is a common phenomenon in investing.

Investors need positive reinforcement to make decisions. We want to be verified by advice and what others are doing.

The end result is an investment decision that is not the result of individual choice. The tulip mania is a classic example of herd mentality. Towards the end of the 16th century, the demand for Dutch tulips skyrocketed. Investors, eyeing a quick buck, flocked in to buy tulip futures. The price of tulips skyrocketed before the bubble finally burst in 1937.

John Huber, manager of the Saber Capital Fund said, "My observation is that independent thought is extremely rate, which makes it valuable… Understanding this reality and being aware of our own human tendencies is probably a necessary condition to investment success in the long run."

SELF-SERVING BIAS

The self-serving bias is a common cognitive bias that distorts an investor's thinking. In essence, the self-serving bias leads us to credit ourselves for successes but blame failures on other causes.

This delusion perpetuates poor investing decisions and limits our ability to learn. Not knowing what you don't know is probably the single most dangerous flaw in investing.

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The best defense against this cognitive bias is to review each investment decision and see if your investment thesis had played out in the first place. Were your investment successes built around solid fundamental reasoning or was it pure luck?

Keeping an investing journal can help us keep track and review our investing decisions.

THE GOOD INVESTORS' CONCLUSION 

Billionaire hedge fund manager, Seth Klarman, once observed:

"So if the entire country became security analysts, memorized Ben Graham's Intelligent Investor, and regularly attended Warren Buffett's annual shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies, and investment fads.

Even if they somehow managed to be long-term value investors with a portion of their capital, people would still find it tempting to day-trade and perform technical analysis of stock charts. People would, in short, still be attracted to short-term, get-rich-quick schemes."

Being rational is easier said than done. We humans are built in a way that has helped us survive for thousands of years by making decisions based on fear and greed. So going against these human emotions is innately difficult.

But to be good investors, we need to appreciate and overcome these human emotions and biases. By overcoming our emotions and biases in investing, we are more likely to make sound investing decisions that give us the best chance of long-term investing success.

This article was first published in The Good Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.