Investing | Investing 101

What Is Investor Psychology, and Why Does It Matter?

It might seem strange, but human behavior and the psychology behind it play an important part in investing. It’s true: calculations steal the spotlight. Professional investors build statistical models, follow trends with technical analysis, incorporate news on the economy in their fundamental analysis, and they review the financial performance of companies. However, be that as it may, investors don’t deal exclusively with numbers.

At the end of the day, the fate of an investment rests on a decision – buy or sell. And since people are crucial in the decision-making process (regardless of the aid they receive from all kinds of software) it all comes down to the human factor.

Below, we will take a look at economic theory and how it relates to investor behavior. In essence, a new discipline, known as behavioral finance, needed to be established to provide a more precise explanation of people’s attitudes towards money and its effect on the economy. This discipline draws on insights from cognitive psychology to provide a better understanding of decision-making in the world of investing.

Don’t worry, this article is not all theory and concepts. There are no lengthy cautionary tales on investing either (although there is an abundance of examples); instead, what we want to offer you is just a standardized breakdown of the most common mistakes investors tend to make when they decide on their next steps in managing investments.

The myth of the rational investor

For a long time, the dominant view in economic theory was that people act rationally for their self-betterment. As much as this was a mere reflection of the intellectual climate in the past centuries, it did manage to spill over into the real world and influence the way investor psychology was perceived.

Two theories embody this approach: rational actor theory and efficient market theory. The first was developed by Bernoulli and von Neumann, and it postulates that individuals are geared toward utility maximization, i.e. people pursue their self-interest and make rational choices to achieve this. The second is less a proper theory and more of a hypothesis by Eugene Fama, and it supposes that the price of assets depends on the information available.

The underlying assumption of these theories, as it pertains to investing, is that rational actors make decisions in line with their self-interest. As those decisions are based on the latest data, these rational actors are well informed and consistent in their convictions and their actions. This was the traditional explanation of what motivates an investor up until the breakthroughs in behavioral economics in the 1960s.

Indeed, if you take a theoretical perspective, the market seems to maximize utility. But, if you’ve spent a minute studying actual investor behavior, you already know that this is far from accurate. And if you haven’t had an opportunity to rub shoulders with investors, the research in behavioral finance will provide valuable insights, so stick around and we’ll show you why. 

Source: Research Gate

Biases in the world of investment

The broad spectrum of emotions experienced by investors has to factor in somewhere, right? They are not rational all the time. While we all know greed drives bull markets and fear worsens bear markets, reducing the complexity of this issue won’t help either. If investing was that simple everyone would do it, so it has to be more than that.

When viewed from a theoretical perspective, the investment process is inherently cyclical. It starts with gathering information, choosing stocks, acting according to an investment strategy (buying and subsequent selling, if applicable), and then moving onto the next stocks worthy of the investors’ attention. This is nothing new, it happens all the time. 

Emotions arising from investing can shed some light on selected segments of this process, but definitely not on all of them. For example, the greed of an investor doesn’t explain why they would prefer domestic stocks to international, does it? We have to delve deeper to come to a better understanding of investor behavior, and that’s exactly what we’ll do next.

Behavioral finance and investing

This is where the relevance of behavioral finance kicks in. Although behavioral finance predominantly deals with quantitative research, it also recognizes that cognitive psychology is critical for determining the value of assets, which in turn affects investor behavior.

Given the cyclical nature of the investment process, and the fact these steps repeat all the time, behavioral finance is able to point out the typical psychological traps investors are prone to falling into. They are termed behavioral biases and elaborate research papers identify up to fifteen different types, including:

  • overconfidence, 
  • loss aversion, 
  • mental accounting, 
  • anchoring, 
  • get-even-itis, 
  • framing, 
  • confirmation bias, 
  • fear of regret, etc.

Investors and behavioral biases

It’s safe to say that no investor is 100% free from each and every one of these behavioral biases. However, we are more likely to get a clearer picture of their effects on investment practices if we speak in terms of the degrees to which different investors are susceptible to them.

Some behavioral biases are more prevalent among individual (or retail) investors than among institutional investors. For example, the effect of increased media attention on a certain stock is greater for retail investors. This is called attention bias (more on that below), and it has proven true in many documented instances when the participation of individual investors has gone through the roof following a news item or a tweet.

That’s not to say that professional investors are above psychological pitfalls, they just experience them on a different level and in a different way. Research shows that active investors (with big turnovers and large trading volumes that are active every day) don’t yield higher returns relative to passive investors who attach their investments to market indices. In the course of their regular activity, these active investors (basically – traders) constantly fall victim to behavioral biases such as overconfidence and fear of regret. 

The consequences of biased investment decisions

We are no strangers to subjective biases when making decisions in our private lives. This can manifest in many ways – from the mundane to the most profound. When we consider investments, flawed decision-making leads to grave consequences for the venture. 

The negative impact of behavioral biases in investment management can go in one of two directions: investors either keep a losing position too long, or they sell a well-performing stock too soon. But losses can also manifest in a different manner. For instance, amassing trading costs by engaging in excessive activity can significantly reduce profits. In general terms, it’s a lost opportunity.

Hence all the efforts to primarily identify and then manage potentially damaging consequences resulting from the faults of investor psychology.

But before we turn to that, let’s take a look at the dynamic of each behavioral bias. 

Common behavioral biases in investing

There is more than one way to approach this subject matter. Some behavioral biases stem from the inadequate processing of information (confirmation bias, anchoring) and they are strictly cognitive. However, a different set of these errors in judgment is motivated by emotions (fear of regret, loss aversion) and can’t be explained as an exclusive and direct result of cognitive processes.

If we prioritize the portfolio management aspect of investing, or the performance of certain types of assets within a portfolio, biases like mental accounting and familiarity bias will automatically gain relevance. At the same time, if we take the social and cultural route to investor psychology, we might discover that the effects of these biases aren’t the same throughout the world. 

For example, risk is not perceived in the same manner in East Asia and in the Anglo-Saxon world and this is important for cultural finance. On the other hand, cognitive fallacies are rooted in cognitive processes which are basic and universal – and they apply to all of us.

Therefore, we will review the common behavioral biases below (in no particular order) along with their unique consequences and show you how their effects can be mitigated. Most of them appear in influential papers on behavioral finance. You can observe them in the investor by your side (or in you) and you can certainly benefit from learning a thing or two about them.

Confirmation bias

This is a typical cognitive bias that has a hold on everyone, not just investors. Confirmation bias happens when people look for and acknowledge mainly information that supports an opinion they already have. While there is an abundance of facts challenging your viewpoint, you decide to focus only on those that validate your initial idea (or belief).

Consequence 

By separating data based on preconceived notions, an investor can maintain a position that is no longer favorable despite evidence indicating that this is detrimental. Holding on to stocks that are irreversibly tanking is a typical example of this.

Remedy

Incorporate opinions, indicators, and evidence that challenge your established beliefs in the analysis. If the new information is valid, you can change course and avert greater losses. Always judge data on its merit.

Overconfidence

Research shows that people tend to overestimate their own abilities, especially relative to their peers. And this doesn’t exclude experts, who also fail to understand and respect the limits of their expertise. It’s ancient: the more you think you know, the less you actually know. And you are more likely to make a blunder because of this.

Even if you were the first to explain gravity to the world, your capabilities mean nothing when money is involved. A different type of quality is required for success in the market. As Benjamin Graham put it in The Intelligent Investor (and many of us repeat it): “This kind of intelligence is a trait more of the character than of the brain”.

Consequence

Overconfident investors believe they are somehow better and that they exercise a greater degree of control over the transactions than other investors. This easily leads to reckless engagement in rapid trading. Unfortunately, each time an investor enters the market, commissions, taxes, and losses increase costs, so excessive trading will decrease returns.

Remedy

Keep track of your trading activity so that you can introduce some form of negative reinforcement once you exceed a certain predetermined limit. Also, diversify your portfolio to avoid becoming a trader when you want to be an investor. Don’t mess with your confidence levels, however, because if they deteriorate too much, you might also lose the minimal optimistic outlook needed to invest.

Attention bias

When the mind is exposed to popular media, there is a subtle influence on a deep, often unconscious level. It works on literally everyone, and especially on those who simply don’t have the time or resources to delve deeper and learn better. We see this in marketing – how many times have you chosen your next meal because of a catchy ad instead of basing the decision on the meal’s nutritional value? Our need for social proof plays tricks on us. This lovely young lady consumes the product, so why should you miss out on it?

Consequences

The number of available stocks is well in the thousands and investors can’t follow new input on every single one of them. Going for a stock that got some public attention is typical for retail investors who don’t have time on their hands to do thorough research. It proves that we are not immune to herd mentality and it may eventually manifest in investing in a poor stock. Even if the stock was good to begin with, the fact that it attracted a disproportionate amount of attention could destroy what was once a promising deal.

Remedy

Recognize the media for what it is – noise. Acting on a fresh piece of news just because it caught your eye will lead you to make poor decisions if you are not well acquainted with that particular stock. If you encounter the stock for the first time, do your due diligence first. Also, check stocks that get no media attention on a regular basis and you might discover great opportunities. 

Fear of regret 

No one wants to admit they were wrong. It’s a funny aspect of our social, psychological, and cultural makeup – we attach mistakes to our identity and consider poor judgment to be somehow shameful. 

On a personal front, for instance, this may happen when you stay in a relationship just because you have invested a lot in it thus far, and you want to avoid facing failure, even when you know that staying together won’t bring anything good for either party. You know you’re doing something wrong, but you maintain the status quo and postpone coming to terms with it because otherwise, you will experience the emotional pain associated with this loss.

Consequences

Investors avoid selling a stock if they are emotionally attached to the price at which it was purchased. Sounds strange but it’s true. Also, selling a stock that isn’t performing as expected means you accept that originally this was a bad investment. The longer an investor holds on to poor stock, the bigger the loss and more destructive all this becomes. It’s a vicious cycle.  

Remedy

Disassociate your identity from the mistakes you make. Everyone can make a bad move, but those who aren’t able to embrace failure and learn from it fare worse in the long run. Bad outcomes are different from bad decisions. Don’t regret a bad outcome; instead, focus on correcting a bad decision before your inaction contributes to the worst possible outcome. Setting an exit strategy before you buy stock may help curb your emotions.

Get-even-itis

This is similar to what is known as analysis paralysis outside of the financial world. People avoid arriving at a final decision because of fear they will miss out on a better solution that’s waiting just around the corner. For example, you are out to buy new running shoes and you have a good pair in your hands, but you postpone the purchase because you believe that a better model at a cheaper price is available in the next store and you want to keep your options open. 

Consequence

An investment has gone bad, but the investor clings to the position because of unfounded expectations of a trend reversal in the future. The decision to liquidate the position is postponed in the name of breaking even or even reaping potential rewards further down the line. Usually, the investment doesn’t recover and the losses are increased because of the baseless decision not to sell.

Remedy

Take the loss. Go about this in a similar way to how you’d go about overcoming fear of regret and practice risk management strategies that will diminish the impact of any given loss. Research and diversify.

Familiarity bias

We stick to what we know and this hurts our investing prospects. It’s not just an observation borrowed from cognitive psychology, but a finding proven in the seminal work on home bias theory by French and Poterba. Although, you can definitely find examples of this in your everyday routine. Do you go to the same bakery every day because they make the best pastries or because you are comfortable with the level of familiarity established over time? Do you prefer your hometown over any other city on the face of the Earth just because you’re used to it? There’s certainly some damage to internalizing the saying better the devil you know than the devil you don’t know.

Consequences

Retail investors prefer buying stocks from companies that are based in their state. This can happen to fund managers too, and the results are mixed. They choose what they are familiar with because of geographical proximity or exposure to media that features these items more often. Eventually, investors miss out on opportunities with more favorable prospects available in foreign (or out-of-state) markets.

Remedy

Take a look outside your filter bubble – there is no lack of alternatives out there. Also, this behavioral bias is slowly fading away as the world is becoming more interconnected than ever before.

Anchoring

As much as we like to think of ourselves as well-informed and careful analysts, we actually base a lot of our judgments on the first interaction with a stimulus. That’s not to say we don’t know any better. Most of us are capable of comprehensive analysis, but we simply don’t include it in the decision-making process. 

Instead, we opt for a random piece of data that suits a specific reference point (an anchor) in our cognitive model, mood, personality, or experience. A typical example of this are retailers who inflate prices unrealistically and then follow it up with a “discount” so that the selling price of their products seems cheap to customers.

Consequences

Investors consider the price at which the stock was purchased as a benchmark, regardless of whether this price was way too high to begin with. When the same investor is faced with new similarly priced stock, the stock may seem cheap when in fact it is nothing but. It can go beyond this as well. Investors may overemphasize any random data (recent performance, historical trends, irrelevant research, etc.) and suffer losses because of it. 

Remedy

Resist the temptation to act and delay the decision until you can verify the value of new data. Anchoring can also be used in your favor if you adjust what you do know (and have researched) to set your own anchor when you weigh available options.

Hindsight bias

We all know this one: having an explanation for an event after the fact. Influence on outcomes established with the benefit of hindsight is not always admissible as proof for assigning blame in courts. Unfortunately, not all processes in life are as diligent as court proceedings. And this bias can lead people to believe they predicted that something would happen before it actually happened.

Consequences

The real danger of hindsight bias manifests when investors are convinced they can predict future events because they successfully predicted past events. If they base a decision on such “predictions” the market might surprise them – and not in a good way.

Remedy 

Make peace with yourself – you only know the outcome of the situation because you have a better vantage point now. Base your future decisions on the best information available at the time. Consider the worst-case scenario and put risk mitigation measures in place.

Loss aversion

Traditional economic theory posits that high risks are correlated with high returns. On the other hand, groundbreaking research in behavioral finance (Daniel Kahneman and Amos Tversky) shows that people are actually more sensitive to loss. They would go to great lengths to prevent a loss, while simultaneously ignoring or at least not really enjoying the gain.

Consequences

Since investors are more weary of losses, they are likely to check losing stocks more often. This is known as myopic loss aversion and might lead to a premature sell of stock that is otherwise stable in the long term. They also easily accept sure gain rather than dealing with possible loss. This results in selling winners too soon and holding on to losers too long.

Remedy

Fight your curiosity and don’t check the status of stocks too often. Take advantage of software and place a stop-loss order on your position to overcome loss aversion.

Mental accounting

Kids ask parents for a lot of stuff, but their requests are not always considered solely from the perspective of cost in terms of money. For example, a kid may ask for a motorbike worth $1000 and his dad can say “We can’t afford that”, but when the kid asks for a trumpet worth $1000, that same parent will allow a purchase of the musical instrument. Now, how does that work – you either have money or you don’t, right? 

This is mental accounting in action. People tend to compartmentalize money based on the label they give to it. Also, it’s much easier to spend money that seems to come from nowhere (like gift vouchers, tax refunds, or house money extended to gamblers) than money coming through a regular monthly paycheck.  

Consequences

Individual investors will be more cautious when spending money that comes from a retirement fund or from their kids’ college savings account. The different responsibility institutional investors feel when trading with someone else’s money is also another example of this. In practical terms, it can manifest in investors being reckless with unexpected profit coming from stocks. Or the other way around, they might continue to hold a position on the market just because the investment used to be a big winner.

Remedy

Do your best to perceive money as money and nothing more or less. Creating attachment to hard-earned money or being frivolous with extra money are both to be avoided if you are to use them for investing.

Gambler’s fallacy

When a gambler is experiencing a series of defeats – they are just on a losing streak. And usually, they believe this is because something or someone is bringing them bad luck. Obviously, this gambler is perceiving patterns where none exist. This goes the other way too and applies to winning streaks as well. 

Consequences 

It’s easy to overestimate or underestimate actual probabilities during prolonged exposure to unfavorable events. If an investor sees trends where there are none and takes action on these assumptions, the move can prove to be costly. When prices seem to drop, investors sell too soon, and when prices seem to bounce back, they start buying too soon. 

Remedy

Estimate probabilities based on available data and don’t qualify a trend until evidence supports your assumption. You might believe that you have lost enough already and it’s time for a change of luck, but the market can prove otherwise and expose your irrational decisions as detrimental.

Beyond behavioral finance 

Overcoming behavioral biases is hard for newcomers and seasoned investors alike, possibly because you are up against yourself – a number of influential authors on investing have pointed this out in the past.   

However, as soon as you acknowledge that such biases plague your decisions and you start to comprehend their impact on active investment management, the task is immediately easier. Then, it becomes only a matter of addressing the issue and incorporating fail-safe tactics in your daily investment process. 

There is a multitude of risk management strategies you can adopt in your playbook. With the help of software, for instance, you will not only distance yourself from the rollercoaster of emotions, but you can also eliminate or limit the opportunities to make a mistake.

Just keep in mind that, in the end, it’s your own self that you have to tame.