The Psychology of Investing

THE PSYCHOLOGY OF INVESTING

Investing should be easy, just buy low and sell high, but most of us have trouble following that simple advice.  Why is it so hard?  It has to do with fear, greed, and something called the Investment Psychology Cycle.

As the market cycles upward it draws investors in, but they may pay too high a price.  When the market cycles downward, fear sets in and investors may sell, often at a loss. Want a real world example? Between Sept 1st, 2008 and February 28th, 2009 the stock market lost over 40% of its value*.  The drop offered the potential opportunity to buy low, but instead many panicked and sold at lows.  How do you break the cycle?  Discipline and sound advice may help . . . don’t get greedy when the market rises, and don’t panic when it falls.  Stay balanced, stay diversified, and stay patient and you may potentially come out on top.

The market meltdown triggered in 2008 by the global financial and economic crisis has left a legacy of pessimism that continues to rule the minds of many investors despite subsequent periods of both economic and market recovery. While some investors remain on the sidelines frozen by indecision, others seem to shift between asset classes with every mood-changing headline. Left unchecked, these emotions trigger systematic irrational behaviors that are repeated over and over, potentially leading to serious investing mistakes. Understanding our emotional state and putting plans in place before emotions take over can help prevent poor investment decisions.

Predictably Irrational

The reality is that all individuals are far less rational in their decision making than believed or understood. Consequently, people may either be either more cautious or confident than statistical probability would dictate, and they routinely misjudge the odds for success or failure (Kahneman & Tversky, "Prospect Theory: An Analysis of Decision under Risk").

It seems that not only are people far less rational in their decision making than theory assumes, but left to their own devices, many people also consistently repeat mistakes over and over again, even when the error has been previously been pointed out. Even when provided with a reasonable argument, oftentimes the human brain nevertheless has a strong tendency to make decisions based on irrational emotion. Working together, emotion and reason should balance each other out, but studies show subconscious activity actually precedes and determines conscious choice (Kahneman & Tversky, "Mental Accounting Matters"). This can lead to numerous investment behavioral mistakes.

Five Behaviors that lead to Investment Mistakes

1) Loss Aversion - The Pain of Loss Outweighs the Pleasure of Gain
No one wants to lose money. Loss aversion refers to the deep pain investors feel upon taking a loss and the lengths to which they will go to avoid that pain. The pain from loss is measurably greater than the pleasure from gain. Since 2008 many investors have been reluctant to invest in equities, instead preferring to remain in low-yielding savings vehicles that may even deliver a negative real return after inflation.

2) Holding fast to the Past  

Anchoring is the tendency to focus on an early decision as input for the future decision to the exclusion of other information. This can bias future decisions and cause to make bad decisions, or be unable to facilitate good ones.

3) Herding - Our Tendency to Follow the Crowd
This is a normal human behavior and perfectly rational for certain situations. However with investing, herding can lead overbuying (or selling) as we follow the masses. This behavior has lead to market bubbles, euphoria, and wild market swings. A painful bubble experience has been the recent real estate rise and eventual burst that triggered a global debt bust that has yet to be resolved.

4) Information Bias
Rather than analyzing all relevant information prior to making a decision, people are prone to rely on whatever information is most easily recalled, which can be incomplete and/or emotionally charged. We can also rely on one person or one source, neglecting to research and multiple counselors for our understanding.

5) Compartmentalizing
Many investors treat money differently depending on where it comes from, where it is kept, and how it is spent. They make take to great a risk with some moneys, while being overly cautious with other moneys . . . not looking at their overall picture and treating it holistically. They may view a tax refund a "found money" rather than allotting it to saving and investing, or they may keep their long term retirement money in a fixed option at returns below inflation for a long period of time.

Effective decision making is the result of individuals understanding their own biases & emotions and planning ahead. Seek counsel of a Qualified Financial Advisor, use technology to overcome biases before investing. Investors need to know themselves, their risk tolerance, and have an Investment Plan. Studies show that investors who follow a written plan are more successful and more satisfied with their investment results (Ipsos Reid, Value of Financial Advice Survey, 2001).

*Google Finance, Jan 2013, Stocks are represented by the Standard & Poor’s 500 Index (total return), an unmanaged index that is generally considered representative of the U.S. stock market. Index performance is not indicative of the past performance of a particular investment. Pas performance does not guarantee future results. Individuals cannot invest directly in an index.

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