Psychology of Investing: The Power of The Mind

What does it take to become a good investor? The answer is simple, right? Diversify, keep costs low and recognize that markets are unpredictable. However, if it is so simple, and everyone knows the rules, then why some fail and some succeed? You cannot explain a change with a constant variable. The variable that we are looking for is a human factor. Investors are human beings, not machines or computers capable of sophisticated calculations. On good days it’s a blessing, on bad days it’s a curse.

Investors are usually faced with dilemmas: to invest or not, to sell or not to sell. Fear is the strongest motivator when it comes to investing. There is a risk of buying a losing stock and reporting a loss. According to a loss-aversion theory points, which points to another reason why investors might choose to hold their losers and see their winners, investors may believe that today’s losers may soon outperform today’s winners. However, Meir Statman of the University of Santa Clara notes, “There are enough papers now that show risk is not what underlines outperformance. It is emotion; it is sentiment.”

Behavioural finance is a study of economics that utilizes personal psychology and looks at it when investors or traders think about making a financial decision. Behavioural finance aims to understand how personal psychology is prevalent in the decision-making process of investors. Over the past 15 years, there has been a steady increase in the use of behavioural finance concepts to select stocks and construct portfolios. Instead of giving in to fear, investors should ask themselves about the consequences of repeating the same purchase if the security was already liquidated, and whether they would invest in it if they had the chance to do it all over again.

Investment is a game and apart from the rules, one needs to know about psychology of the players. There are a few psychological biases that the researchers have identified that play an important role in financial decision-making:

Herding — buying or selling because everyone is doing it

Familiarity bias — “buy what you know” strategy may feel good, but it will give you a concentrated, high-risk portfolio instead of a diversified one.

Loss Aversion — humans will have a far greater emotional reaction to a financial loss than to a financial gain of the same amount.

Overconfidence — overconfidence serves well to politicians, entrepreneurs and life in general, but it blocks success on the investment markets. Nobody is more knowledgeable than the market. Not admitting that you don’t have any control will make you lose even more of it.

Activity bias — the drive to achieve goals and to be active can be counterproductive when it comes to investment, investors need to exercise constraint and be patient and not to invest in times when market is highly volatile.

Trend-following — humans have a well-developed ability to see patterns in nature, financial markets although sometimes resemble a law of jungle, they do not follow natural laws. The short-term market moves are random and there is no guarantee that the emerging trend will continue.

Thus, besides diversifying, keeping the costs low and recognizing the unpredictability of the market, an investor needs to have the psychological restraint to maintain the strategy throughout a span of investing. Our human nature does not adapt to the rules of the financial markets, and that is why we need to take human psychology and biases into account for a successful trading. Relying on your gut feeling can be helpful, but investors need to employ fundamental analysis to learn more about the securities they want to purchase.

Although humans are not sophisticated machines, one thing worth learning from a computer is resilience. No matter how many times the program does not get the results, it tries again and again without giving up. Winston Churchill used to say, “Success is the ability to go from one failure to another without losing your enthusiasm.” Instead of being slaves to our mentality, we need to turn the mental blocks into building material for successful investment techniques.