I’ve never been a big stock guy. The same could be said for real estate or art or any other type of investment. I’ve always preferred to build my own business since, as ironic as it may sound, I’m very risk averse. At least with my own business, I know the variables that can affect it. I know nothing about real estate. I know a lot about stocks (which is why I’ve never been big on it). For the rest of the world, the situation is the same.
Everyone has to find some way to build up equity. With inflation, it’s the only way to build up enough assets to retire or to make any sort of major purchase. So why is it that people always hear stories about getting burned in their choices? The reasons are limitless. So, I want to focus on a less popular one, and that’s the psychology of risk.
An Intro To The Mind
From the day someone is born, they are conditioned by their environments. Every day, a person’s beliefs and values are being molded. It’s a survival mechanism that’s telling our subconscious what to do so that we don’t die, and to a lesser degree, what to do to prevent being put in a situation that might engender dying.
It’s the main reason we all have jobs. We need money to pay for rent, food, clothing and so on. So once we’re in a place where the present needs are taken care of, the mind can explore the future. Doing so, many people start to save money. They go to their finance professional and ask about investments.
The professional might say things like “risk tolerance” or “time horizon” or maybe they threw in the old warning about “market timing.” Almost anyone who sells mutual funds will have been taught to manage their clients’ expectations so that they don’t freak out when they make losses in their investments (which I think is crap, but let’s leave that for another post). Despite all this, many investors still follow their gut and typically make very poor decisions.
If Only Markets Behaved
If you had a $1 million to invest and you knew for a fact that the markets would go up, would you invest? Of course you would. If you knew for a fact that the markets would go down, would you invest? Of course you wouldn’t.
What if you didn’t know what the markets would do? Ideally, if you asked any savvy investors, they’d tell you to buy low and sell high. That makes sense. Buy something when it’s really cheap and sell it when it’s really expensive. Rinse and repeat. But our minds won’t let this come intuitively to us. There are two very powerful reasons why our minds act this way, and it comes back to our survival instincts.
Authority and Social Proof
Funny enough, but the stock markets have very little to do with the companies themselves. It simply tracks people’s perception of the company. So, when a stock or the real estate markets go up, the perception is that people are liking it and that it’s doing well. And vice versa when it goes down. But since we know that this is the opposite of what savvy investors should do, why do people do it? Most people simply can’t help it.
Firstly, the social proof that rising markets have is almost irresistible. When the markets are going up, people tend to follow the crowd. This is important for most people since most don’t have the time to do the background research themselves; they’re completely dependant on the judgement of others. When they see people buying a certain stock, they tell themselves that since everyone else is doing it, it must be a good decision.
For the same reason, authority plays into effect here. When you’re sitting in front of the TV with a “market analyst” saying that the markets are performing great and that it’s a great time to invest, it’s pretty hard not to listen. We give an incredible amount of credibility to public figures.
Listen To Yourself
Following social proof and authority may get us into trouble at times, but as I mentioned, it’s an important survival mechanism. We simply don’t have the time to look at every situation carefully and inspect it nor do we have the knowledge. But finance is an area where few can afford to not know (pun intended).