Investment Psychology Definition
Investment Psychology refers to studying investor mindset, analyzing the emotions, behavior, traits, ideologies, and beliefs that steer investors to make certain investment decisions. These decisions comprise selling, buying, or holding securities and other assets and financial instruments in financial markets. An investor is influenced by multiple factors derived directly or indirectly from their general financial behavior.
While dealing with different securities and financial assets, investors face various scenarios, and not all investors behave in the same manner or make the same decisions. This is because certain emotional, mental, logical, and other cognitive factors impact decision-making, giving rise to thoughts specific to their situation. Hence, investment psychology falls under the purview of behavioral finance.
Table of contents
- Investment psychology is the study of an investor’s financial behavior, specifically while making investment decisions in financial markets.
- It explores the direct and indirect factors that influence an investor while making investment decisions. This concept is explored in great detail in behavioral finance.
- Behavioral finance also helps understand market dynamics and trends based on people’s perceptions.
- Investors can refer to investment psychology books to understand and overcome biases while making investment decisions.
Investment Psychology In Finance Explained
Investment psychology, a branch of behavioral finance, explores risk management, financial planning, and financial decision-making in the context of less-analytical concepts, such as emotions. A person’s risk-taking ability and long-term goals are vital, which constitute the analytical side of decision-making, in addition to trading strategies, risk appetite, and market information. On the other hand, emotional and psychological aspects impact an investor’s decisions; sometimes, investors assign more weight to these factors while reviewing the pros and cons of investing in specific assets.
When influenced by psychological factors, investors sell, buy, or hold securities and assets based on sentiment, cognitive bias, and beliefs instead of market conditions, economic conditions, risk tolerance, and financial goals (immediate and long-term). While the latter are parameters investors must consider for sound decision-making, factors like emotions and cognitive biases bring unfounded considerations to the fore. This can be tricky since investment decisions based on thoughts and feelings can introduce vulnerabilities in the form of undue risks and losses.
According to emotional investment psychology, investors’ most common emotions are fear, risk, greed, and hope. These factors get amplified when people are concerned about money management, investing, and financial decision-making. It is important to control the influence of such factors on investment decisions to ensure the decision-making approach remains logical and well-balanced. Not falling prey to various psychological traps (discussed in the next section) is crucial to facilitate clear-sighted decisions.
Investors wish to earn the maximum profit possible through the capital invested in markets. However, in reality, the possibility of risks, losses, and debt cannot be ignored or trivialized. An individual’s investing activity in any market is always susceptible to negative outcomes. These outcomes shape an investor’s thought process, investment strategy, experiences, and mindset. Due to these apprehensions, investors might make decisions based on emotions, past experiences, and present trends.
Psychological traps in investment can adversely influence an individual’s ability to evaluate situations and develop a realistic understanding of market dynamics. These traps have been listed below:
- Anchoring trap: It refers to a scenario where investors overestimate a company’s future growth based purely on misconceptions of what the company is currently worth. They attach excessive value to historical performance data or past milestones and benchmarks, leading to short-sighted decisions.
- Confirmation trap: In this situation, investors seek help from others who have achieved good results by making certain investment decisions. Typically, these decisions support an investor’s own beliefs and ideas. So, instead of relying on the relevant data, they prefer advice or input from those who have succeeded in similar situations. Such advice or opinion can be right, but the chances of receiving inaccurate information cannot be ignored.
- Blindness trap: This refers to an investor not making the right move despite sufficient contradictory information being available during decision-making. They choose to ignore any information that contradicts or negates their views. Eventually, these investment decisions backfire, and investors are forced to bear losses.
- Sunk cost trap: When investors refuse to accept the mistakes made while investing in a particular asset and hold on to such assets despite contradictory signals, they have fallen prey to the sunk cost trap. In such situations, they prefer to wait, expecting their investment to bounce back and give them good or anticipated returns.
- Irrational exuberance trap: According to this psychological trap, investors neglect market uncertainty and are driven by the idea that past successes will be replicated in the future. Such investors wrongly believe that no uncertainty exists in the market. This indicates an irrational exuberance as these investors believe positive future outcomes are promised by a stock’s past performance.
- Relativity trap: It refers to an investor comparing their situation with others around them. However, such comparisons are almost always wrong because people operate under different circumstances, assumptions, and expectations. Hence, a decision that works well for one person may not offer the same results to another. Triggered by other people’s investments, investors mindlessly copy their decisions.
- Superiority trap: At times, investors think they do not need to heed the advice received from experts and can easily beat the market based on independent analysis. They make investment decisions independently with ill-founded confidence, even after being advised to act with caution. Such behavior is called a superiority trap.
- Pseudo-certainty trap: Investors stuck in this psychological trap focus only on the original investment amount (capital) while making investment decisions. They prefer to ensure its safety and make decisions accordingly. However, they do not take the necessary actions if given a chance to increase their returns. They limit their risk exposure by safeguarding their capital and avoiding new investment avenues even when growth opportunities arise.
Below are two examples that facilitate further discussion.
Suppose Jeremy has just started trading. He started out making small investments. Later, while eyeing a particular stock, he consulted a market analyst and purchased several shares of this stock. Due to market fluctuations, the stock value declined, resulting in losses.
This prompted Jeremy to think that all analysts offer incorrect advice. Now, he only invests in stocks he believes will grow. Jeremy’s investment psychology has been impacted by his past experiences. His decisions are driven by fear, and his decision-making process is lopsided due to bias. It can be concluded that Jeremy has fallen into the superiority trap, where he believes he knows best.
Let’s say, Jennifer has recently started investing in the stock market and is determined to earn huge returns in a short time span. This indicates she is driven by greed. Jennifer has created a portfolio with many stocks because she believes these stocks will grow and give her high returns. Now, Jennifer’s portfolio is over-diversified. She may not be able to reap the benefits she wants due to sectoral volatility.
Since she paid no attention to stock movements across various sectors, Jennifer failed to take into account that some industries might not perform well. It can be concluded that Jennifer’s emotions (greed and excessive confidence) affected her investment psychology.
The importance of this concept has been discussed in this section.
- It is a concept studied under behavioral finance that helps make judicious decisions related to investment and financial planning.
- It explains why people do what they do, especially in financial markets, helping financial advisors, analysts, and experts gain in-depth knowledge of the markets and people’s behavior in these markets.
- It enables economists and businesses to understand market trends. It also facilitates policy formulation.
- The study of investment traps and the awareness of their existence can help investors overcome them through conscious effort.
- Investment psychology allows investors to understand the importance of logical and critical thinking while making investment decisions.
How To Avoid?
Below are some ways investors can apply to stop themselves from succumbing to investment psychology in finance.
- Applying logic and analyzing the stock market well is advisable to ensure investors do not make rash decisions that fall beyond their financial capacity or risk appetite.
- Learning from other people’s investment mistakes is better than repeating them.
- An investor should ideally study their emotions before investing but without ignoring data-backed information about their own financial situation and markets. This can help them avoid biases.
- Copying the investment strategies of other investors is not recommended.
- Finding the right balance between trading and investing can help avoid cognitive biases.
- An important psychological factor investors must strive to avoid is overconfidence. For this, they should stay abreast of the changes taking place in the economy and financial markets.
- Following trends blindly to make portfolio changes is not recommended since an investor may lose sight of their financial goals (immediate and long-term).
- It is advisable to avoid making decisions based on regret. Sometimes, investors are driven by regret and think they will lose the opportunity to earn money if they do not act fast.
- Reading investment psychology books offers insight into how different investors apply varied strategies for success in financial markets.
Frequently Asked Questions (FAQs)
The two most important emotional factors affecting investment psychology are fear and greed. In a bullish market, investors tend to invest more, driven by hope and greed, to make the maximum profit. Conversely, when the market is stagnant or undergoing a correction, investors prefer short positions for fear of making a loss.
Although many types of investor personalities are observed in the stock market based on emotional and cognitive elements and influence, the main four types of investor personalities based on risk appetite are Cautious, Individualist, Methodical, and Spontaneous.
Some useful investment psychology tips are:
– Investors with a long-term vision are known to benefit as they practice objective investing.
– Those who stay rational and logical in every market situation typically profit from investing activities.
– Investors who do not copy others generally make rational decisions based on solid data.
– Those who accurately identify their risk exposure and make balanced investments usually benefit from investing in financial markets.
This has been a guide to Investment Psychology and its definition. Here, we explain the concept with its examples, traps, importance, and how to avoid it. You may also find some useful articles here –