How many times have your emotions misled you in stock investing? Let’s explore how to overcome psychological biases in investment.

TradingKey - Stock investing is not merely a numbers game; emotions such as optimism, panic, and greed constantly influence your decisions.

Consider this: when the market is soaring, don’t you feel exhilarated as well? Watching the numbers in your account rise can make your optimism feel intoxicating, leading you to think, 'I should buy more! Maybe it'll double by tomorrow.'

However, when the market suddenly takes a nosedive, panic hits you like a cascade of dominoes. As you watch your profits slowly disappear—perhaps even turning into losses—you instinctively think, 'I need to get out!'

This emotional roller coaster reflects humanity’s inherent response to loss and gain. Yet in the stock market, those who allow emotions to dictate their actions often fall into the trap of 'buying high and selling low.

(I) Overconfidence — The Illusion of Investment Competence

Overconfident investors often overestimate their abilities and knowledge, leading to overly optimistic predictions about market trends.

They believe they can precisely capitalize on every investment opportunity and achieve returns that significantly exceed the average.

Individuals demonstrating overconfidence typically engage in two prevalent behaviors:

First, they trade frequently, convinced they can profit from “buying low and selling high.”

For instance, a beginner investor who has glanced through a few articles on candlestick patterns might become overconfident and decide to trade on a daily basis—buying renewable energy stocks today and offloading consumer stocks tomorrow.

Consequently, transaction fees gradually erode their profits, akin to boiling a frog in warm water; they might unknowingly lose up to 20% of their earnings.

Second, they disproportionately invest in individual stocks, firmly believing that “the selections they've made are all winners.”

As a result, they allocate substantial capital into only a few stocks. They often overlook the importance of diversification and fail to recognize the significant risks inherent in putting all their eggs in one basket.

If these stocks perform poorly, investors risk incurring substantial losses.

What factors contribute to individuals getting caught in the overconfidence trap?

On one hand, past successful investment experiences can create an illusion for investors that they possess extraordinary abilities.

For example, occasionally selecting a stock that hits its price ceiling may lead them to believe they are inherently skilled, confusing luck with talent.

On the other hand, access to abundant information can foster arrogance.

Today’s investors can easily find research reports, news articles, and funding flows; however, those who are overconfident tend to selectively accept information that supports their views.

For instance, when favoring a particular stock, they might focus exclusively on positive reports while disregarding risk warnings—eventually falling into the mindset that “what I believe is true = it is true.”

(II) Loss Aversion — Why Do You Hold Onto Losses Yet Sell Profitable Stocks Too Quickly?

Loss aversion is a well-known psychological concept where people tend to view losses as more distressing than equivalent gains that are enjoyable.

Generally, individuals are far more affected by losses than by gains.

This mentality manifests in two typical ways in the stock market:

First, investors tend to stubbornly hold onto losing stocks, often digging themselves deeper into loss.

When a stock drops by 10%, they might think, “It hasn’t fallen much; it’ll bounce back soon.” If it declines further to 20%, they may reason, “If I sell now, I’ll incur a real loss; I’ll just hold on and see.”

When it falls by 30%, the thought transforms into, “I’ve already lost so much; I might as well ride it out…” Consequently, what could have been a small loss that was swiftly cut turns into a significant and unbearable deficit.

Second, investors often rush to sell winning stocks too quickly, missing out on substantial gains.

For example, when a stock rises by 10%, they start to panic: “What if it pulls back? I should take my profits now.”

After selling, if the stock then climbs another 20%, they console themselves with the thought “At least I made some profit.”

However, when it eventually rises by 50%, they slap their thighs in frustration and lament that they should have held onto it.

Why does this happen?

From an evolutionary psychology perspective, humans are innately more sensitive to losses; hence the brain prioritizes avoiding loss.

However, in the stock market context, this instinctive response can be detrimental: holding on to losing stocks essentially reflects an unwillingness to acknowledge mistakes, lulling oneself with fantasies of “it might go up.”

Conversely, selling profitable stocks quickly stems from a fear of losing certainty; this "small gain is good enough" mentality masks their underlying fear of risk.

(Source: Shutterstock)

(III) Recency Bias — Misled by Short-Term Trends

Recency bias refers to the tendency of individuals to rely more heavily on recent events or information when making judgments and decisions while disregarding long-term trends and data.

In stock investing, recency bias can mislead investors, causing them to make erroneous investment decisions based on short-term market movements.

Recency bias notably impacts behavior, especially during bullish market conditions.

For instance, if a particular stock hits its daily price limit for half a month straight and everyone around you is showcasing their profits, you might feel envious and think, “With such a hot sector, it’s bound to keep rising for months.” As a result, you may end up chasing the price higher.

In reality, those stocks may already be trading at price-to-earnings ratios that far exceed the industry average—merely the outcome of short-term speculation. Once the frenzy subsides, the stock price could tumble back to its starting point while you find yourself trapped at elevated levels.

The danger of recency bias lies in your tendency to use a “microscope” to scrutinize short-term fluctuations while employing a “telescope” for long-term logic.

For example, if a leading consumer company’s stock drops by 15% due to one quarter missing earnings expectations, you may focus solely on this recent decline and overlook the fact that its net profit has grown by 20% annually over five consecutive years with a robust competitive moat.

Ultimately, this leads you to sell at rock-bottom prices and miss out on subsequent rebound opportunities.

(I) Use Processes to Counter Emotions — Establish Rules Before Making Trades

Many stock traders operate on instinct—buying more when prices rise out of joy and selling off when they fall out of fear, completely driven by their emotions.

The key to overcoming this behavior is to develop an investment process in advance and adhere strictly to the established decision-making framework.

Step One: Define Your Investment Mission and Goals

Are you aiming for short-term gains or saving for retirement?

These objectives require distinctly different strategies. For example, a short-term trader might set a 5% stop-loss, while a long-term investor would focus more on the intrinsic value of the company.

Step Two: Allocate Capital Wisely — Don’t Put All Your Eggs in One Basket

Conservative investors might allocate 60% to bonds, 30% to stocks, and 10% to gold; whereas aggressive investors might opt for 70% stocks, 20% in funds, and 10% cash.

However, it’s critical that no single stock constitutes more than 10% of your total capital—not because it limits your potential gains, but to prevent emotional decisions leading you into an “all-in” bet during moments of stress.

Step Three: Implement an “Emotional Circuit Breaker”

Before buying, clearly define your stop-loss and take-profit points (for instance, sell if the stock drops below its 20-day moving average and target a gain of 50%).

This pre-set strategy can help avoid last-minute decisions that are influenced by emotions.

(Source: Freepik)

(II)Cultivating Contrarian Thinking

In the stock market, there is a saying: "When most people are right, it often signifies the onset of a mistake."

Therefore, when 90% of individuals are discussing a particular stock, it's essential to ask yourself: Does their optimism have any fundamental basis?

Identify Emotional Extremes Using Data

When the "Greed and Fear Index" falls below 20 (indicating extreme fear), it might be a good opportunity to buy at discounted prices; conversely, when it rises above 80 (indicating extreme greed), you should be cautious that the game of hot potato may soon end.

Create an “Anti-Intuitive” Decision Checklist

When the impulse to chase rising prices surfaces, make yourself answer: “Is this stock's P/E ratio lower than the industry median?

Will its earnings growth over the next three years support its current valuation?”

When in doubt about selling at a loss, ask yourself: “If I were out of this position right now, would I still buy this stock?”

If the answer is no, then you’re merely avoiding the pain of loss rather than making a rational decision.

(III) Physical and Psychological Approaches

Physical Isolation — Reducing Sources of Emotional Stimuli

Avoid obsessively watching intraday charts; glancing at them for just 30 minutes before the market closes each day is sufficient.

Just as someone on a diet should steer clear of snack cabinets, an investor should distance themselves from "emotional junk food" in the form of real-time price fluctuations.

Conduct weekly reviews focusing on quarterly earnings reports and industry trends instead of becoming entangled in daily price movements.

Psychological Fortification — Embracing an "Imperfect" Investment Philosophy

No one can buy at the absolute low or sell at the absolute high; striving for “fuzzy correctness” is more important than achieving “precise errors.”

For instance, if you buy a stock around 20 and eventually sell it for 50—though it didn't peak at $60—you’ve still made a 150% profit, which is more than satisfactory.