The Psychology of Investing – How Emotions Affect Your Decisions

Originally published in 1971, this groundbreaking text was the first to explore investor psychology, with a focus on how biases affect investment decisions, and how overcoming these biases can lead to more financial success. Excellent as a supplement for upper-division behavioural finance courses and for individual investors and financial planners.

Practical hint: Use a piece of financial software to see all your assets and obligations as an integrated whole before making an investment, so that, even though already pre-programmed by habit, you don’t permit the type of compartmentalisation that gives rise to irrational behaviour and decision making.

Fear of Loss

It is normal to argue that fear, although an essential and evolutionary important part of human decision making, can be dysfunctional if its effects extend beyond actual risks. However, there are also heuristics and cognitive biases that accompany fear and influence investment decisions, such as constructing the probability of negative events solely on their ease of retrieval (availability bias); or seeking out information corelating to the organisational (or personal) decision whereas ignoring evidence against it (confirmation bias). A second well-known behavioural bias is loss aversion, whereby investors tend to value a potential loss of 10 per cent in the value of their portfolio much more highly than a profit of the same size, leading them down an ineffective road toward optimum portfolio returns, by selling off those investments that are giving rewards too soon, and hanging on to the losers for too long.

Fear of Regret

This fear of regret can discourage us from investing in potentially riskier but more rewarding ventures, thereby encouraging us to overstate our aversion to regret in ways that inhibit or delay many forms of decisionmaking. Investor psychology is the analysis and description of the effects of cognitive and emotional factors on investing decisions, from impeding to enhancing a risk-averse mindset, and from demotivating to animating more riskier behaviour. Rational and successful financial decision making oblige you to know investor psychology. In earlier generations, experimenters might have told participants: ‘Keep your feelings under control.’ That is, they’d ask participants to attempt to mute or suppress emotional intensity. Of course, that might not be a phenomenally good idea, but it turns out it might not even be a very effective one: we’ve found that those individuals who feel more acutely are also more capable of controlling any valence (or emotional direction) bias that couldimpact the decision process.

Anger

The studies show that the feeling of anger blunts people’s ability to think more rationally. Angry individuals tend to opt for quicker, less considered decisions, are more likely to fixate on salient features that frame their decision-making, and are more likely to attribute mistakes to others as a way of avoiding self-blame. The researchers promoting this anger primed their study participants by telling them that their hopes and dreams that they had just reported on were critically cast aside, and then asked to assess written essays produced by an imagined second participant; those subjected to anger-provoking interventions found these essays less intelligent and interesting than the participants in the control groups. Michal Maimaran, a professor at Kellogg, has found in research that anger can be channelled for good if it’s directed towards corporate goals. If your company’s sales flatlined and you’re pissed off – direct your anger towards getting something done (and even more so at actually getting it done!).

Greed

In the short-run greed can certainly propel a market rally, or sharpen a rally that has propelled the price of a stock to unsustainable levels. But in the long run, the aftershocks of greed can be devastating to the investor. Psychological research has linked greed to higher levels of psychological entitlement (Huseman et al, 1987; Kickul and Lester, 2001), and research has shown that those who have higher levels of entitlement are more likely to feel violated and be sensitive to loss than those who have low entitlement. Empirical research demonstrates that greed magnifies our attention to losses relative to gains, further increasing the importance of thinking through asset allocation decisions whenever we invest. If you are a risk-avoidance type, for example, then you should limit your exposure to stocks – again, this could help reduce loss sensitivity.

Anxiety

Whether it’s choosing a formally acceptable outfit or deciding whether to take a job offer, anxiety can render us incapable of choosing. Laboratory studies show that, when we get anxious, we deactivate parts of our brain that are necessary for weighing up the possible outcomes of our actions; also parts that are important for flexible decision making. You will be much better off if you’re able to step back and notice: ‘I must be really scared about this.’ And then, once you know why you’re anxious, you can try to push yourself toward making the best choice you can. An invaluable text for undergraduate and graduate courses on Behavioural Finance, Investments, and Personal Finance, it looks at how psychology affects investing, how overcoming those psychological biases can lead to financial success, and how those biases can drive the variations in investor behaviour.