The Psychology of Investment
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How Psychology Affects Investment
What makes a good investor? Thorough research? Superior analytical skills? Great instincts? All of these play a role, of course, but they count for nothing if an investor is not able to make decisions rationally in the face of their own emotional responses and biases.
Experts in behavioral finance believe that even the best and most experienced investors make irrational decisions based on the emotional, social, and cognitive influences that we are all vulnerable to. Having a good understanding of investment psychology — and thus being armed against one’s own ingrained biases — can help an investor optimize their performance.
Understanding Behavioral Finance
You don’t have to look too far to see examples of investors behaving unpredictably and making irrational decisions, led by their emotions and individual psychology. For example, one of the most common investor behaviors is herd mentality, which leads people to follow the wisdom of crowds. Another is loss aversion, where negative outcomes in the past can damage an investor’s confidence and make them overly cautious in their decisions. The best and most experienced investors should have the confidence to make their own decisions and to hold their nerve in the face of losses.
However, even experienced investors may fall victim to a range of subconscious biases. Some of the most common are:
- Overconfidence: A type of emotional bias whereby investors hold the belief that they have a greater degree of control over their investments than they actually do. This can lead an overconfident investor to put too much faith in their own ability to identify a successful investment, for example.
- Confirmation bias: The tendency for people (and not just investors) to respond more positively to information that backs up their existing opinions, while rejecting any evidence that contradicts these opinions.
- Gambler’s fallacy: The unfounded belief that if a random event has occurred already, it is less likely to happen again.
- Get-even-itis: Another bias that puts us in mind of the casino; this is the desire to quickly make up for a loss, and to behave irrationally or recklessly in the process.
Behavioral Finance in Practice — What Makes a Good Investment?
So, armed with an awareness of how one’s emotions can be one’s own worst enemy when making financial decisions, what can behavioral finance teach us about good investment choices?
Investments can have a strong emotional component. To prevent decisions from being driven by emotions, the most important thing to remember is to strategize, and then stick to the strategy. Planning helps one remain rational, and part of that means getting finances in order before thinking about investment. An investor should be clear about how much they can realistically afford to invest (and to lose) before making plans.
Plans should be long-term. An uncertain market and volatile investments mean that there may be short-term losses, so patience is key in combating loss-aversion. Returns may take longer than expected, and investors should remember the long-term strategy, rather than giving up at the first sign of adversity. Another way to avoid making irrational decisions is to slow down one’s thinking. This is generally good practice when it comes to making big financial decisions, as it is another way to prevent emotional responses.
Herd mentality — following what others are doing — is a natural instinct, and can help an investor to feel safe; conversely, however, it might not bring benefit in the long term. In some instances, it can be beneficial to look out for those cases where there is a strong market opinion about a particular asset and invest the opposite way. Investors shouldn’t be afraid to go against the market, making their own bold, unique decisions (as long as they are rational ones!) and sticking to them.
Avoiding Common Biases
When it comes to bias, it’s important to think about measures and behaviors that will counteract one’s own weaknesses. With that in mind, let’s return to the common biases already mentioned:
- Avoiding overconfidence: Of course, investors need to be confident in their decisions. But to avoid the bias that comes from overconfidence, it can help to consider the average person and their abilities: Everyone has a desire to win, and many people have the belief that they can be a winner. Belief in itself, however, will not inoculate you against failure.
- Avoiding confirmation bias: Here, it’s important to always test your theories by actively looking for counterarguments. Be honest with yourself and try to remain flexible and open-minded. Seeking out an objective opinion and analysis of any investments will also help prevent confirmation bias.
- Avoiding Gambler’s Fallacy: Probability is a curious beast; just because those dice came up ‘snake eyes’ doesn’t mean they’re any less likely to do so again. It’s always vital to consider the true probability that a trend will reverse, rather than relying on what feels probable.
- Avoiding Get-Even-Itis: To avoid this emotional response, focus on the long-term strategy. Losing money and making money are both inescapable aspects of investing; take the losses in your stride and don’t take extreme, rash, or unaffordable steps in an attempt to turn things around.
Rationality Breeds Success
Naturally, understanding the markets and how to respond to them is a crucial component of an investor’s toolkit. However, behavioral scientists believe that investors, even armed with this knowledge, often make irrational decisions based on emotions, creating inefficient investments and missing opportunities to make the best returns.
The science of behavioral finance considers some of the behaviors, attitudes and biases that affect every one of us, influencing our decision-making process when it comes to the most important financial decisions that we make. Studying behavioral finance — and thereby learning how to master one’s own emotions and irrational responses — can be the crucial difference between being a good investor and becoming a great one.
