Yes, you read it right! Even between the statistics and alien-like language of data in the investment world, there is a psychological study about investor behaviours.
Don’t underestimate this school of study. One would argue that investor psychology is just as imperative as one’s statistical prowess in stock market prediction!
Whether you are a novice or an experienced investor, you should at least know the fundamentals of such a concept.
Trust me. There have been many venerated investors today who have wasted so much time and money simply because they succumbed to the investment psychological traps.
However, before getting into that spicy information, let’s understand what investor psychology is.
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Define Investor Psychology
Investor psychology, in simple terms, is just the study of the psychology of investors. However, if you know anything about psychology, you know it’s not as simple as it sounds.
The crux of psychology is the study of behaviour, attitude, belief, and emotion. The subject of such could range from infants to the elderly. Investor psychology, on the other hand, focuses on investors.
You might have the impression that investors are all very logical. But still, they made some huge, illogical mistakes from time to time.
Why?
We could approach this topic from the lens of investor psychology, understanding that perhaps, regardless of how logical investors are, they are human.
And so long as they are human, psychological influence is inevitable.
Hence, in investor psychology, we are more concerned with identifying the psychological traps investors tend to fall into.
Investor Psychology: What are The Cognitive Biases or Psychological Traps To Beware Of
These investment psychological traps are also known as cognitive biases. Albeit cognitive, some of these biases have prevalent emotional elements in play.
Let’s see what they are.
Confirmation Bias
Let’s say, for example, you have purchased one of the best penny stocks in 2023 you can find. After researching and analysing the company’s projected growth and stability, you realise it has great potential.
To avoid feeling like you have made the wrong choice, you proactively look for information that reaffirms your investment decision while disregarding the conflicting ones.
This is confirmation bias in investor psychology.
It’s almost similar to what they call an echo chamber today. Except this time, you create one for yourself.
You shut down any information that might suggest you have made an investment blunder, and it will ultimately lead you to an investor’s Achilles heel – willful blindness.
Even if there is news reporting the instability of the company whose stocks you just purchased, you would probably think, “That might be just fake news. My research tells me otherwise.”
Although it seems too silly a mistake, it’s all a very legitimate phenomenon in investor psychology.
Therefore, don’t create an echo chamber for yourself. Always be ready to read diverse points of view and to scout for opposing information.
But it’s not easy to do. Having to listen to opposing information that contradicts your belief is anxiety-provoking.
From the lens of investor psychology, this would suggest that there is a problem with your investment capabilities, which might threaten your self-esteem. Hence, the psychological tension arises.
While you may fail to overcome this bias, you are now at least aware of its existence. Then and only then can you take a small step in making the necessary improvements.
Loss Aversion
Imagine you have gained, for example, ten thousand dollars in your investment. How do you feel? Great, happy, satisfied?
What if that very same investment has lost you ten thousand dollars instead? How would you feel now? Would the pain be more intense than your happiness if you were to gain the exact same amount?
We, humans, tend to feel more intensely the negative emotions than the positive ones. This is no exception in investor psychology.
It makes sense if you look at it from an evolutionary psychological perspective. Negative feelings or emotions such as pain, disgust, and anxiety are often important signals for our survival.
This survival instinct passed down from one epoch to another, from one generation to another, and has long become part of who we are.
While this instinct may be pivotal in our human ancestors’ survival, it can be a great hurdle to overcome for investors.
What results is an overly cautious investment approach. Blue-chip and value stocks become constant options for investments. On the other hand, stocks issued by companies with a new background, such as hydrogen stocks, might get a side-eye.
(You can learn more about different types of stocks here.)
You can be cautious and have a lower-than-average risk tolerance, but don’t go too extreme with your caution. After all, without risk, your investment won’t have a noticeable return.
Anchoring Bias
History has always been the best lesson, but it’s not the only place where you can find valuable lessons.
Often, investors get so hung up on a company’s past performance that they disregard any relevant, new information. After all, a company’s past performance is usually the first piece of information the investors receive when researching.
In investor psychology, the practice of using the first piece of information to make an assessment is anchoring bias. The first piece of information serves as an “anchor” for all future decision-making processes.
While a company’s past performance is often the “anchor”, it’s not the only one.
For example, the market price of certain stocks could be the “anchor”, too. In this case, investors would use the market price as the sole factor when deciding whether to invest in certain stocks.
Sometimes, the anchoring bias could work the whole other way around.
How so?
The investors might get too hung up on the recent market price, review, and opinions (the first piece of information) that they entirely disregard the company’s past performance.
So, depending on what information the investors first learn of, that information will take precedence over other information.
Herd Mentality
When discussing investor psychology, you heard many people say, “Don’t be a sheep and follow the crowd.”
Yes, it’s true. Such a notion encourages people to be independent thinkers, imperturbed and analytical.
But how many follow the advice?
Do you still remember the almost unfathomable hype around NFT? Did you happen to be part of it?
It was so predominant that it even broke into the bubble of Hollywood, with many A-list celebrities promoting it. It has also become a very popular case study in investor psychology.
I’m not here to discredit anything about crypto and NFT. We have even written an article about some of the best NFT marketplaces you can check out.
The point is to remain calm and don’t go astray from your personal investment strategy. It’s tempting to join the hype because you might fear missing out on a great opportunity.
“Since everyone is investing in it, it must have a great potential,” you wondered. With this mindset, you might go beyond your risk tolerance and detract from your initial investment goals.
“Bubbles” are usually used in the investment lingo to describe an investment craze. And you should know that they all burst ultimately.
Therefore, no matter how much noise there is about a certain investment, always do your due diligence and research before swaying along with the crowd and succumbing to this investor psychology trap.
Overconfidence Bias
While confidence is attractive, overconfidence will only invite disaster. The same goes for the investment psychology.
This is often the case for the experienced investors.
For the novice, you might want to check out the other article I wrote on how to invest in stocks for beginners.
Study over study suggests that overconfident investors tend to engage in overtrading, which might result in a huge loss of money.
When you are convinced that you have all the information you need about an investment and that your prediction is accurate, it’s good to think twice.
Again, confidence is good, but overconfidence is a costly self-inflicted blindness.
Irrational Investment in Investor Psychology
A quick history lesson: in investor psychology, there is a notion called the efficient market hypothesis (EMH). It suggests that market prices will reflect all the rational information because the agents, or investors, make rational choices.
However, as illustrated, humans are susceptible to various cognitive biases and are very…emotional.
Do Your Feelings Care about The Facts?
This quote is actually paraphrased from a YouTuber by the name of Zoe Bee when she, in her video essay, critically dissected Ben Shapiro’s infamous quote, “Facts don’t care about your feelings.”
As it turns out, feelings do take precedence over facts when making investment decisions for many investors. Of course, it’s a generalization in investor psychology, but it seems to be the case on average.
Why so?
One should understand that humans are not void of emotions or animal instincts and are just rationally programmed robots with binary codes.
When stressed, your brain releases certain neurotransmitters, affecting your cognitive faculties and rational behaviors.
Additionally, we don’t live in a vacuum. Wherever you are, there will always be other people around. And as long as that’s the case, you can’t run away from the influential societal factors.
Herd mentality is the epitome of what societal factors could influence one’s behaviors. This mentality can also be called social proof, one of the persuasive tactics in social psychology. It states that we will be more likely to do something if we know others are doing it, too.
As you can see, internal and external factors drive many investors to invest irrationally.
But can we control them?
Now, we are getting into a very philosophical territory.
This is often the debate between determinism and free will. I won’t get into it very much. Still, the debate essentially revolves around whether humans can act as agents independently of any other influences, including biological and environmental ones.
Read also: 10 Best Stocks For Beginners with Little Money
Conclusion
Whether you think your cognitive faculty is strong enough to withstand environmental or biological influences, you should at least know the existing cognitive biases.
A discerning investor is one who exudes confidence while knowing his/her blindspots, as every investor should.
If you are all too new to investment, equipping yourself with this knowledge of investor psychology can help you avoid future blunders or loss of money.
This article might not give you much useful information on the stock market. Still, building a solid foundation for your investment strategy before your money is involved is crucial.
Therefore, not only should you keep yourself updated on stock market news, but you should also pay attention to recent academic findings on investment psychology.
