Investor psychology is the study of how emotions, beliefs and mental shortcuts affect investor choice. Finance is generally treated as a mathematical discipline, but real decisions are made by individuals experiencing pressure, uncertainty and time constraints. Therefore, investors may purchase high, sell low, and disregard sound, long term investment plans. The psychological characteristics of an individual impact how he/she perceives risk, filters information and develops confidence. By understanding the underlying psychological characteristics, we can understand market fluctuations and more importantly, develop methods that enable investors to develop steadier and more consistent financial decisions.
1. Emotional States Influence Perceived Risk and Time Frames
Fear and greed are not just headline-grabbing, they also significantly affect investor behavior. When stock prices increase, investors are more likely to take additional risk than they had originally intended. Conversely, when stock prices decrease, investors may become panicked and limit their potential losses.
Additionally, fear and greed can direct investors’ decisions to favor short-term comfort over long-term goals, resulting in poor timing, particularly during times of volatility.
Some of the most common emotional stimuli for making investor decisions include:
- Fear of losing money during market downturns
- Frustration and excitement due to rising stock prices
- Regret for missing a potential profit opportunity
- Increased anxiety due to constant exposure to stock price fluctuations via media outlets and mobile applications
While fear and greed can affect an investor’s rational thinking process, they can still make informed decisions based upon their own financial objectives.
2. Mental Shortcuts (Cognitive Biases) Create Poor Decision Making
In order to make rapid-fire decisions in the face of large amounts of data, humans rely upon mental shortcuts (cognitive biases). In investing, cognitive biases can be detrimental to one’s ability to make rational decisions about investments. Additionally, cognitive biases are often disguised as “common sense” which can help to mask the fact that they exist.
Two of the most common types of cognitive biases include confirmation bias and recency bias. Confirmation bias refers to seeking out information that confirms your existing belief about the market. Recency bias refers to the tendency to treat recent events as if they have a greater significance than historical events.
Common types of cognitive biases that impact financial decisions:
- Overconfidence: Overestimating the accuracy of predictions regarding future market direction
- Anchoring: Treating past prices as factual prices for future reference
- Loss aversion: Feeling the pain of losing money more intensely than the pleasure of gaining money to the same extent
- Herding: Engaging in herd mentality by making investment decisions based solely upon the investment decisions of other investors
By developing the ability to recognize and avoid these biases, investors can begin to build a more balanced portfolio, delay selling stocks until the right moment, and make investment decisions based upon a well thought-out plan rather than a whim.
3. Market Information Generates Reactive Decisions
Stock markets provide continuous updates to investors through a variety of mediums including: headlines, charts, social media posts and daily price movements. However, not all of this information is relevant to investors. Excessive market noise can cause investors to react to each new piece of information, thereby increasing transaction costs, raising taxable income, and creating inconsistency in results.
A less reactive decision-making process would involve:
- Checking the current stock price less frequently
- Creating a written set of rules prior to purchasing/selling stocks
- Concentrating on long-term metrics such as dividend yield, P/E ratio and book value per share rather than daily/short-term price movement
- Creating goals for the portfolio that serve as guidelines for investment decisions during stressful times
By reducing market noise, investors can focus on the signals that align with their investment strategy.
4. Psychology Influences Long Term Discipline
Patience is a major component of long-term investing; however, developing patience is difficult during times of market uncertainty. Investor psychology plays a significant role in determining whether an investor adheres to a long-term investment strategy, rebalances the portfolio as needed and resists making impulsive decisions that deviate from the original plan.
It is more challenging to adhere to a long-term strategy when:
- The goals for the investment are ambiguous
- The level of risk assumed by the investor exceeds his/her comfort level
- The expectations of the investor are unrealistic
- The investor compares his/her performance to that of other investors too frequently
Investors who recognize and manage their psychology as part of their overall risk management plan will be able to make more consistent and dependable financial decisions. Although markets will always be unpredictable, investors who develop the self-discipline to follow their own well-thought-out plan will ultimately be rewarded with more stable financial outcomes.