Written by: Ida Saari
THE MIND OF AN INVESTOR - FOMO, EMOTIONS & HEURISTICS
How do psychological heuristics affect our decisions as investors?
Throughout history economists have perceived humans as rational animals, that make coldly rational, objective decisions.
However, theories are often very far from reality, and already for some decades have one specific area of economics, behavioural economics, rebelled for this view, and embraced the irrationality of humans. Behavioural economics as well as the behavioural theory of finance see that our humane weaknesses can be seen in all communication situations and decision making, which is why they are relevant to consider both in human relationships and business. Many cognitive, emotional and social factors expose our minds to illogical thought chains and mistakes.
Profit from understanding behaviour
Psychology of investing is a field of behavioural economics that studies all factors affecting our investing decisions. Understanding these factors is useful so we could make better decisions and avoid possibly expensive errors. In this post we will discuss these factors and consider their significance when building an investment strategy.
Subconsciousness plays tricks with our minds - cognitive factors
Our minds tends to form subconscious thought chains, heuristics, that can lead us to make wrong estimates when investing.
“An investor that believes their possessed stock to perform well, will more likely focus solely on the positive information about the company to confirm this belief.”
Confirmation bias is a tendency to search and absorb the kind of information that we already agree with, and on the other hand ignore contradictory believes. On average, people are more likely to invest in companies that they are familiar with. Additionally, an investor that believes their possessed stock to perform well, will more likely focus solely on the positive news and information about the specific company to confirm this belief.
Optimism bias stands for our tendency to overestimate our own investing skills and knowledge. Usually investors believe that they are better at forecasting market movements, if they have succeeded in the past. On the other hand, failed investment decisions are often blamed on outside factors, that “have nothing to do with the investor themselves”. Optimism bias might lead to excessive risk-taking, and it’s existence is good to remember in both successful and not-so-successful trades.
Sometimes the first observed information (f.ex. the first observation of a stock’s price) works as “an anchor” when making investment decisions. For example, if an investor has bought a stock at a specific price, they might be unwilling to sell it later at a lower price, even if the stock’s value has gone down significantly. Anchoring bias also works the other way around: investors perceive stocks to be worth more if they’ve been overvalued for a long time in the market.
In addition to this, investors also have a humane tendency to overestimate probabilities of unlikely events, if they are associated with personal experiences or if they’re discussed in the media. An investor might think, for example, that the general probability of financial banks going bankrupt is higher, if a single bank has gone bankrupt recently. In reality no probabilities have changed, although sometimes our irrational actions might lead to real consequences, such as bank run. This illusion is called the availability bias.
“Man is by nature a social animal”, said Aristotle, the legendary Greek philosopher. We have a tendency to make decisions based on other people’s opinions and views, and it’s very much the reality in what comes to investing, too. We might buy something just because it seem to be popular or trendy, even thought we know that in more effective markets this can be a weak strategy. If everyone is able to note the growth potential of a stock, the value reflects to it immediately. In order to control the group thinking bias, it can be useful to learn how to look for information independently.
Emotional investor is vulnerable to make bad choices - emotional factors
People are emotionally very complex creatures, and in addition to the cognitive biases numerous emotions affect our decision making. Fear of losing money can lead to premature sells and really low risk tolerance. Greed on the other hand can cause excessively gambling. Overly optimistic investor ignores the risk factors and focuses on the pleasant-sounding profits, when a pessimistic one might not even have the courage to begin.
“An investment said to have an 80 % chance of success sounds far more attractive than one with a 20 % chance of failure. The mind can’t easily recognize that they are the same.”
When FOMO hits - social factors
Social structures and pressure also have a huge effect on our willingness to make decisions. For example, FOMO (the fear of missing out), doesn’t only have to do with our friends gatherings or vacations that we didn't join in, but is also a big part of the world of investments. FOMO can get investors to follow others blindly (group thinking bias), and invest in things that they are not personally so familiar with. For example, from the point of view of investing psychology, the sudden popularity of cryptos can be viewed as this kind of social phenomenon.
When building your own investment strategy it’s good to analyse your own goals as well as your risk tolerance. When your goals are clear, it can be easier to make rational decisions that back up your strategy. In addition to this, it’s important to stay informed about the general market situation and the changes around your investments. Following the trends is vital, but you should also feel encouraged to try to work on your independent analysis.
Eventually, it’s good to recognise our mental shortages and biases, because with them in mind we can learn to control our investing behaviour better. Aiming for objectiveness and quality information most likely leads to better solutions and more sustainable investment strategies.
As my sources I used these books, and I can definitely recommend reading them!
Daniel Kahneman - Thinking Fast and Slow (2011)
David Orrell - Behavioral Economics (2021)
Picture: Discover Magazine