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The Psychology of Financial Investments

  • Bhumika Dutta
  • Aug 01, 2022
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In finance, although most decisions are taken thoughtfully and rationally, there might be a few instances where emotions influence the investor’s decision. Investors are mere humans, and they can behave in unpredictable or irrational ways. This is what Behavioral Finance is all about. 

 

This relatively new topic, "behavioral finance" aims to explain why people make illogical financial decisions by fusing traditional economics and finance with behavioral and cognitive psychology theories.

 

In this article, we are going to understand behavioral finance and delve into the psychology of investors.


 

The difference between behavioral finance and traditional finance:

 

Most of the popular and established financial theories state that individuals are well-informed and consistent in their decision-making, especially when it comes to financing. 

 

First, people appropriately adjust their views in response to new facts. Individuals then make decisions that conform to norms. Although this approach seems appealingly straightforward, it is obvious that humans do not always behave logically. In actuality, people frequently behave irrationally—in systematic, unproductive ways. 80% of individual investors and 30% of institutional investors make more emotional decisions than rational ones.

 

The development of behavioral finance has been facilitated by these departures from theoretical expectations. To better understand actual financial behavior, behavioral finance focuses on the cognitive and emotional components of investment. It also draws on psychology, sociology, and even biology.


 

The Role of Emotion in Investing:

 

In investment, psychology, emotions, and irrationality all play significant roles. When we are young, we have an inflated sense of ourselves that shields the way we view the world. The maturing process that comes with becoming older includes realizing our true "size" in the world.

 

As many observers have noted, an investor's emotional composition is more crucial to their potential to succeed in the stock market than their intelligence or bookish knowledge. Although this is a straightforward statement, it is believed that most investors will not consider its implications when making their investment choices.

 

If you believed that stock market trading was just about calculating statistics, you might be startled to hear that your psychology plays just as much, if not more, of a role in making significant decisions. A topic that is not only very fascinating but also very helpful to investors is the study of the mind and behavior as it pertains to how we invest. Emotional investing is real, not necessarily a good thing.

 

It is reported that usually, the best investors can set strategic goals for themselves patiently and improvise them as required. 


 

Investor Behavior that can harm investing returns:

 

There are certain investor behaviors that one should avoid if one wants to be a good investor. This pattern of behavior might help you in your day-to-day life, but it will have a contrasting effect on your financial investment.

 

Here are a few of them:

 

  1. Investors are Overconfident:

 

Humans tend to have an optimistic outlook on the world in general. In a 1980 research that had nothing to do with money, between 70-80% of drivers claimed to be in the safer half of the distribution. Numerous studies of physicians, attorneys, students, and CEOs have revealed that these people overrate their contributions to prior successes and have overly optimistic self-evaluations. 

 

Overconfidence Bias:

 

Although having confidence may be a positive quality, it can also result in biased investment choices. Overconfidence is an emotional bias. 

 

Overconfident investors think they have more influence over their investments than they do. Overconfident investors may overestimate their capacity to recognize successful investments since investing entails complicated future projections. This can cause harm to the investment.

 

Active Trading:

 

It has been demonstrated in many studies that traders who trade often and actively underperform the market.

 

Self-Attribution Bias:

 

Investors that engage in self-attribution bias assign positive outcomes to their activities while negative outcomes are attributed to other forces. This bias frequently manifests as a kind of self-preservation or self-improvement. Self-attribution bias can cause investors to overestimate their abilities, which can result in poor performance. 

 

Investors should keep a record of their failures and triumphs and create accountability systems to lessen these consequences.


 

  1. Investors have a phobia of Loss:

 

Risk and return have a clear correlation and a trade-off, according to established financial efficient market theory. The return on investment increases as the related risk increases. According to the hypothesis, investors look for the maximum return possible given the degree of risk they are prepared and able to accept. Contrary evidence has been found in behavioral finance and related studies.

 

Fear of Loss:

 

Prospect Theory: An Analysis of Decision under Risk”, a seminal study by behavioral finance pioneers Dan Kahneman and Amos Taversky found that investors are more sensitive to loss than to risk and potential reward, according to research. Simply said, people would rather avoid loss than get an equivalent gain. According to some assessments, people prioritize losses more than possible rewards. People will prefer to accept a lesser, certain loss than take a chance on a significant expense, especially if the chances of an expensive occurrence are quite remote.

 

Disposition Effect:

 

Investors frequently hang onto equities for too long in the hopes of a comeback because they are afraid of losing money. The tendency of investors to liquidate profitable holdings while holding onto losing ones is known as the "disposition effect." The result may result in investors paying more capital gains taxes, which is counterproductive given that the restrictions encourage holding gains back as long as possible.

 

The importance of client risk of loss will not change for wealth advisers and financial professionals. Reminding clients that "loss" is a relative term and that you may assist them in identifying a suitable reference point from which a gain or loss will be determined is necessary.


 

  1. Herding:

 

Following the crowd is herding. This might result in doing research that is too casual or buying a stock that is dependent on reputation. Following the crowd might result in an investor missing out on undervalued but solid stocks in the market.

 

These actions are all typical manifestations of the human psyche. None by itself will undermine a sound investing plan and routine. They are return-limiting when combined. Additionally, an investor who engages in one or more of these behaviors is likely to repeat them, causing greater harm.


 

  1. Investors become Aggressive:

 

This investor is hard-charging, impatient, and results-oriented. He is perhaps more prone than other profiles to some of the psychological traits we have discussed. It is challenging to incorporate this profile into a long-term plan that calls for purchasing equities and keeping them for protracted periods.

 

Unless he can restrain his impulse buying and selling and has a very long time horizon, an aggressive investor is a dangerous investor. If he is sufficiently diligent, he can also set a restriction on the percentage of his securities in his whole portfolio. This type of personality is almost universally better suited to trading than investing.


 

  1. Investors misuse information:

 

Anchoring:

 

Investors frequently cling to a view and use it as a subjective benchmark for future decisions. People frequently make judgments based on the first information source to which they are exposed (such as the first purchase price of a stock) and struggle to change their opinions in the face of fresh information.

 

Investors might use a stock's purchase price or market index levels as an anchor while they are making investments.

 

Representativeness Bias:

 

Investors that have this bias tend to judge an investment based on how it has performed recently. As a consequence, they buy stocks when they have increased in price with the expectation that they will continue to climb, and they avoid buying companies when their prices are below their underlying values. People frequently base their decisions on prior experiences, coming to conclusions too hastily and with faulty information.

 

Gambler's Fallacy:

 

The gambler's fallacy, which is connected to representativeness bias, involves identifying patterns where none are present. Investors frequently attempt to impose order when there is truly chaos. Gamblers who think a run of good luck would come after a run of poor luck at a casino gave the phenomenon its name.

 

Attention Bias:

 

Purchasing and selling an investment should be two sides of the same coin, according to conventional financial theory. In other words, in principle, while selecting whether to purchase or sell, investors look for the same signal. This is since buying investments need investors to sort through hundreds of stocks, yet their ability to comprehend information is constrained.

 

On the other hand, because they frequently only sell equities they already own, they do not have the same issue when selling. Professional or institutional investors tend to spend more time seeking and using computers to do analysis, thus this impact doesn't hold for them as much.

 

An investment's attention-getting features might occasionally work against it by reducing its usefulness.


 

Also Read | What is Equity Investment?



 

Psychological Traps that investors must avoid:

 

Here are some psychological traps that investors must be cautious of:

 

  1. Anchoring Trap:

 

The anchoring trap is the over-reliance on one's initial assumptions. Imagine placing a boxing wager and picking the boxer based only on who has landed the most blows in their last five bouts. The statistically more active fighter may win if you choose him, but the fighter who throws the fewest punches may have won five matches by knockout in the first round. It is obvious that when a measure is removed from its context, it can lose all of its significance.

 

You need to keep your mind open to fresh ideas and sources of information to avoid falling into this trap. You should also be aware of the possibility that any firm might exist today and vanish tomorrow. For that matter, any management may simply disappear.


 

  1. Confirmation Trap:

 

People frequently look for others who have made and are continually making the same error when they fall into the confirmation trap. Instead of consulting the individual who initially provided you with incorrect advice, make sure to acquire unbiased information from new sources.

 

  1. Sunk Cost Trap:

 

This is about safeguarding your past choices or decisions mentally, which is frequently terrible for your finances. Accepting that you made the wrong decisions or that you let someone else make them for you is difficult. However, if your investment is poor or losing value quickly, it is best to exit it and move on to something more promising as soon as possible.


 

  1. Blindness Trap:

 

Situational blindness can make things worse. Even those who are not particularly seeking confirmation frequently merely ignore the current market reality to put off the terrible day when the losses must be faced.

 

You may be experiencing the blinder effect if you are aware on a deep level that there is a problem with your assets, such as a significant scandal at the firm or market warnings, but you just read the financial headlines online.


 

  1. Relativity Trap:

 

Additionally, the relativity trap is there, ready to misdirect you. Each person has a distinct psychological makeup in addition to a certain set of circumstances that include their profession, family, future career opportunities, and inheritance probabilities. This indicates that while it's important to be aware of what others are doing and saying, their circumstances and points of view may not necessarily be applicable in other contexts.


 

  1. Irrational exuberance trap:

 

Investors act as if there is no uncertainty in the market when they start to think that the past predicts the future. Uncertainty, sadly, never goes away.


 

  1. Pseudo-Certainty Trap:

 

This statement is a comment on how risk is perceived by investors. Investors will reduce their exposure to risk if they anticipate strong portfolio or investment returns, effectively safeguarding the lead, but if it appears that a loss is imminent, they will seek out increasing amounts of risk.

 

In general, investors prefer risk when their portfolios are struggling and don't need any additional exposure to potential losses, and they shun risk when their portfolios are doing well and could tolerate more. The mindset of trying to get everything back is partly to blame for this. Investors are prepared to increase the risk to "reclaim" money but not to generate new capital.

 

Also Read | Introduction to Investment Banking

 

Conclusion:

 

Investing is not just calculations, it could involve both art and science. Technical and fundamental analyses are important. Investor mentality is similar. While a stock's intrinsic characteristics, such as its PE ratio or profits per share, are beyond the control of an investor, that person can surely assess his or her psyche.

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