The Psychology of Investing explained.

The Psychology of Investing is the study of how emotional and mental influences affect an investor’s decision-making process. This includes what the investor believes, how they act and interact with the markets, and how they respond to different market cycles. Many investors do not consider the impact that psychology has on their success.

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This topic is not glamorous and does not attract those looking for quick wealth. However, if you are a serious investor looking to compound capital over a long period, understanding and mastering your behaviour is essential. Investors who think that behaviour does not affect them often have the biggest biases.

Understanding your own investor psychology is crucial, as both profits and losses can influence your behaviour. Many times, emotions and psychology influence our decisions, causing us to behave in unpredictable or irrational ways.

Financial markets are not solely driven by fundamentals. If it were left up to computers and algorithms, the market would be entirely efficient. However, when we factor in the inefficiencies of the human mind, it creates mismatches that create opportunities.

The investor’s chief problem, and even his worst enemy, is likely to be himself.

Benjamin Graham

Understanding the basics of Behavioural Finance.

Behavioural finance is a field of study that focuses on understanding the various psychological factors that influence investors’ decision-making process. It delves into the emotions, biases, traits, ideologies, and beliefs that shape an investor’s investment decisions, such as whether to buy, sell, or hold stocks or how much risk to take on. An investor’s general financial behaviour, including various direct and indirect factors, can significantly impact their investment choices.

Investors are not always rational when it comes to making investment decisions. Unlike traditional finance theories, behavioural finance recognises that investors often exhibit irrational behaviour and may be influenced by psychological biases.

While the conventional assumption among economists and corporate finance theorists is that investors always act rationally in order to maximize their own wealth, this does not reflect the reality of human behaviour. In fact, emotions and other factors can have a significant impact on how investors make decisions in financial markets.

Investor psychology plays a key role in the functioning of financial markets, as it can help to explain why asset prices sometimes experience dramatic swings. As well as why we go through boom and bust cycles. By understanding the psychological biases that can lead to irrational investment decisions, investors can make more informed decisions and improve their overall investment performance.

The Psychology of Investing and “efficient markets”.

It is important to recognise that financial markets are made up of “human beings” who are not perfect operators. I believe a market can never truly be efficient unless you eliminate the biggest participants…us!

Efficient Market Theory states that all public information about companies is available to everyone at the same time, so no one can gain an advantage. If all the information is accessible to all, then stocks are priced with all the available information, and it is difficult to outperform the market.

I disagree with this theory because as an active investor, I have been able to generate alpha for my portfolio. Although some people may try to dispute it, the gains already made cannot be taken away.

The EMT ignores the fact that emotions and behaviour create erratic market movements. In a perfect efficient market, even if there is negative news, the stock price would not drop because it would be fundamentally valued at the same price. However, people’s emotions create fear, and they panic and sell.

While the top end of the market is mostly efficient, this is because there is more coverage, the same funds buying the same big companies, and the same Wall Street analysts covering the same stocks. This creates efficient markets, but when something breaks, fear creates price disparity.

In the small-cap market, efficiency is nowhere to be found. Any decent micro or small-cap investor will tell you that. There are so many emotional contributions that affect markets.

Investors can sometimes be naive about frequent insider trading, financial media campaigns pumping ideas, and overly positive earnings reports by incentivised analysts. Price swings may not always be based on publicly available information but rather on greed. It’s important to be aware that all of this creates inefficiencies.

The Cycle of Market Emotions.

The Cycle of Market Emotions is an important concept that every investor should be aware of. It describes the emotional journey that most investors go through when investing in the market. It can be a baptism by fire, a rite of passage to the investing world. The diagram below summarises the experiences that most investors have faced. It is an emotional roller coaster ride that includes fear of missing out, excitement, happiness, disappointment, and even panic.

The cycle of emotions not only explains the individual investor’s journey but also the cycle of markets. During a boom, investors tend to jump into investments they know little about, ride it to the top, think they are smart, and don’t book profits. Then the market goes down, and the entire collection of emotions unfolds.

Being mindful of the cycle of emotions and the biases that come with it can help investors make the right decisions. It is essential to avoid making investment decisions based on emotions, as it usually leads to booking losses more often than profits. Most investors who have a poor initial experience tend to avoid markets altogether in the end.

The cycle wraps up with a sense of panic, extreme negativity, and eventually, surrender and hopelessness, at which juncture investors give up and sell. At this point, the market is likely to have more prospective buyers than sellers, which signals the pinnacle of financial opportunity for investors.

Investors can fall victim to various behavioural biases, from media coverage to social media, and other things that influence their decisions. Therefore, it is crucial to be aware of these biases and to put in the right procedures to help avoid poor decisions. By doing so, investors can make informed logical decisions and achieve long-term success in the market.

Irrational decisions caused by Fear and Greed.

Investors are often driven by self-interest and the desire for wealth, which can lead to irrational decision-making. Fear of loss may cause investors to sell prematurely or avoid entering the market altogether, while the fear of missing out can lead to impulsive decisions.

Unfortunately, these emotional reactions to market fluctuations can cloud judgment and make it difficult for investors to stay focused and make rational decisions. As various psychologists have shown through their research, people are not always rational and are prone to lapses in logic. As a result, emotional investing can be compared to a roller coaster ride, with its highs and lows.

The stock market is known to be a highly unpredictable and volatile space, influenced by a range of factors such as global events, economic indicators, company performance, and investor sentiment. Among the various factors that impact the stock market, two dominant emotions, fear and greed, play a significant role. These emotions can drive investors to make irrational decisions that can either inflate or deflate stock prices.

To measure the impact of fear and greed on the stock market, there is a popular tool called the Fear and Greed Index. The index is a composite measure that tracks a variety of indicators related to investor sentiment.

The fear and greed index is based on the logic that excessive fear tends to drive down share prices, as investors become more risk-averse and sell off their stocks, leading to a bearish market. Conversely, too much greed tends to have the opposite effect, as investors become more optimistic and bullish about the market, leading to a bull market. By monitoring the fear and greed index, investors can gain insights into the market sentiment and make more informed decisions about buying or selling stocks.

The Pitfalls of Emotional Investing on overall returns.

Investors can often be their own worst enemies when it comes to making emotional investment decisions that go against the plan they had in place. Emotional bias can play a significant role in the success of long-term investments. While investors may be correct in their investment decisions, they often make mistakes with timing, over-trading, fear, and greed, which can ruin any potential positive returns.

Rather than economic conditions, it is frequently human psychology that leads to the loss of investments. While investors pay attention to known risks, such as systematic and unsystematic risks, they often ignore the emotional risk factor.

Many investors change their investment strategies frequently, driven by emotions rather than rational thinking. They tend to follow current market trends, read a new style and immediately switch to it without considering the consequences. This unpredictable behaviour often leads to the failure of investment strategies.

Emotional bias often disrupts the plan due to many behavioural contributors. To be successful in the market, it is essential to develop a strategy, implement it and remain patient and consistent while staying the course. Passive investment yields great returns, but investors often want faster compounding and disrupt the process. Hence, it becomes crucial to control emotional bias and make rational investment decisions.

In Summary…

Investors need to be mindful of the role of investor psychology and its impact on their investment decisions. One of the best ways to protect oneself is by having a clear understanding of past market cycles to avoid being caught off guard and tracking your emotions. It’s also important to resist the temptation to get caught up in market booms and avoid panicking during market downturns.

Recognising the influence of emotions on investment decisions is the first step towards managing them effectively. It’s crucial to develop self-control and discipline to make logical decisions rather than impulsive emotional responses. Numerous studies have established that share market volatility is driven by more than just investment fundamentals – investor psychology plays a significant role. By understanding the emotional aspects of one’s behaviour, investors may devise strategies to mitigate the impact of emotions on their investment outcomes.

This blog is a summary introduction to the Psychology of Investing. To learn more navigate back to Psychology and start working through each of the categories to gain a deeper understanding of behavioural flaws so you can maximise your investing journey.