Common Psychological Traps Investors Fall Into

Many investors overestimate their stock-picking ability. Several studies show that 60-80% of individual investors believe they are above-average investors.

The results of overconfidence: - Excessive trading: the more frequently you buy and sell, the more trading costs pile up and returns shrink. In the Barber & Odean (2000) study, the annual return of the top 20% most-active traders was about 6-7 percentage points lower than that of the least-active 20%. - Concentrated investing: a tendency to concentrate in a few stocks without diversification - Refusal to cut losses: continuing to hold losing stocks out of conviction that one's judgment is right

When a stock rises, it seems it will rise more; when it falls, it seems it will fall more. This is herd behavior.

The result of herd behavior in the data: U.S. fund flow statistics show that investors put money in after the market has risen and pull it out after it has fallen. That is, they repeatedly buy at peaks and sell at bottoms.

Dalbar study (30 years as of 2023): the S&P 500's annual average return was about 10.2%. Over the same period, the average investor's return was about 6.3%. The main reason for the roughly 4-percentage-point gap is poor timing (buying at peaks, selling at bottoms).

Anchoring: the psychology of fixating on a specific number. "I bought it at about $74, so it has to reach about $74 before I can sell." You cling to this reference even though the purchase price does not affect the future price.

Status quo bias: a tendency to avoid change. Maintaining the current allocation even when rebalancing is needed, or keeping the existing ETF even when a better one is available.

Disposition effect: a tendency to sell winning stocks quickly and hold losing stocks a long time. In the end, you sell good assets and accumulate bad ones.