You should buy stocks when prices are cheap and sell when they are very high this is well known wisdom. But most of the investors failed to do so because of human psychology that prevent us to buy when prices are cheap (because of fear) and sell when prices are abnormally high (because of greed.).
There are two parts of brain first is emotional (our subconscious part)which is active by default and makes most of the decisions without ever noticed by us. For example reacting to car coming toward us.
Other part of brain is logical where we have to make efforts to activate this part of brain just like solving a math problem we have to think.
For making investment decision one should always go logically. But in reality we fall in trap of our brain and make decision emotionally or we can say that we rely on our intuition which cause wrong decision making and we don’t even realist that we are not rational.
When we think emotionally there are certain tendencies that our brain has adapted in the process of biological evolution. So before taking any decision investor have to look whether any of these tendencies are playing their game.
Human mind is evolved in such a way that when someone gives reason for doing something we tend to believe him or agree to him. This also happens in stock when someone says stock ABC co. will double in one year because of …xyz reasons and most traders generally buy.
We never bother to take effort to crosscheck whether reasons given by him are correct or have some merit.
Management of companies also use this reasoning tendency to fool investors. They take unrealistic assumptions and give flawed reasons to convince audience how their business model we succeed in future.
As a human we always have a belief that there are experts in any field who know everything and questioning them or their wisdom is stupid idea.
Experts are also found in field of equity investments who pretend to know everything. Investors never question experts analysis and blindly follow their recommendations.
Experts give opinion on everything in market. Think about it why these folks who always appear on TV to give their million dollar opinion are not in billionaires list.
Also you might have observed that they give very few sell recommendations in any market situation. Because they have incentive to promote stocks that to demote it as this will hurt their relations with company’s management.
Research has proved that we tend to value any stocks excess when we already hold that stock. Reason is simple that we subconsciously feel emotional attachment for that company this can wreck our re-investment decision and most importantly sale decision.
So before making decision of sell or reinvestment investor should always ask themselves a question “How I would have valued stock if I was not investor in it ? “
Loss aversion is a tendency because of which we fell more pain of losses compared to happiness of gain for same amount of money.
This is most common tendency that cause loss to most of investors as we feel more pain for loss. Hence investors to hold loosing position for more time than winning position in expectation that price will reverse its direction and their position will be profitable. But most of the time this never happens causing more loss to investors.
To avoid this psychological pitfall is advised to put stop loss and follow it strictly.
When people get new information they process it in such a way that their previous opinions remain intact.
As human we are always reluctant to change our views because we have had taken lot of efforts to reach view. This cause investors to hold stocks even when fundamentals of company starts to deteriorate and give himself false expectation that things will be good again .
Warren buffet never looks at price of stock before he himself find out its intrinsic value of a company. Because greatest investor in the world also thinks that this will create preconceptions about company. This will lead to biased analysis of company.
While tracking market day by day sometimes we hear good things about particular company from other investors or advisors or TV anchors. It create good image about company in back of the mind even before analysis.
When we start analysis not only we focus on finding good things about company but also we give more weight to positive factors than negative factors. Thus we perform balance analysis of company.
To avoid such kind of things stop being influenced by the words of others and try to start analysis without any preformed opinions.
Social Pain Tendency
Man from the very beginning of evolution is social animal. We like to spend time with people who think and behave like us. Also we feel very uncomfortable when our views are different than the worlds. This gives rise to herd mentality within us.
But this social tendency is not good for investors. It is one of the prime reason for formation of bubbles because market participant follow one another like a herd of ship and then fall from cliff one behind another.
In order to attain above average returns most of the time we have to be contrarian. Because that only where big margin of gain can be made .
I have seen many investors taking short term position in stock claiming that this is food company and people are not going to stop eating food that is why their trade is well positioned. This is example of irrelevant anchoring because in trading what matters most is trend of price or any news but our mind relate some odd factor just to assure ourselves that whatever we have done is correct .
Inability to link things properly can cause false reasoning and false reasoning lead to bad investment decision.