Behavioural Finance & Investment Psychology

Don’t Forget that You Are Dealing with Humans

One of the biggest mistakes people make when investing or trading, is forgetting that on the other side of their transaction is another person who has his own emotions. This person may feel afraid, anxious, over-confident or greedy. Whatever emotion the other person will feel will affect his decisions if he lacks self-decipline, and since most investors don’t have solid self-discipline, the market is affected by psychological factors just as it’s affected by fundamentals and news.

Where Does Investment or Trading Psychology Fit in the Investment Process?

If you think investment involves the single step of researching a stock before you buy it, then you are dead wrong. Successful investment requires that the investor become aware of all the factors that are affecting the price of the stock he intends to buy. Those factors include researching the fundamentals, staying up to date of world events and local news affecting market prices, looking at the historical price charts and predicting how the market will react to future events.

Here is where investment psychology comes to play: the market may overreact or underreact to an event and so open the door to a good opportunity for either exiting safely or for taking a new position. Just take a look at the following examples to see how psychology of investors can affect the market:

Fear: The strongest psychological factor that influences the market. People may sell fearing that the price will slide down further, or they might fear losing all their savings and so sell their shares at an incorrect timing or at a relatively cheap price.
Attachment: Falling in love with a stock !! Some people fall in love with a certain stock because of the profits they once made out of it. They stick to it forever, forgetting that change and diversification is a basic requirement in today's market.
Greed: When someone starts to get greedy, he may either buy at a high price or buy a large amount of the same share thus illogically increasing his risk.
Optimism: When people get optimistic they usually drive the market higher without having solid fundamentals to sustain these increasing prices. This results in either a minor correction from the market, or in the worst case, a market crash.
Herd behaviour: Thinking that you know less than your peer investor will probably lead you to act like him, buying what he buys and selling what he sells. Usually this leads to major loses (see the herd behaviour).
Anchoring events to time: Some investors may relate certian events to a certian period of time like for example assuming that if a stock market correction happened in February of this year, then this correction is going to happen every February (see this article for more detailed information on that subject).

Investment Psychology and Maximising Your Returns

Knowing about other investors' psychology will help you in avoiding their emotionally driven mistakes as well as enable you to take advantage of these mistakes. Yes, you could survive without knowing about investment psychology, but another investor who knows about it will definitely make more money than you will. Investment is a game of knowledge, the more you know the more money you will make.

Did that help?

Well, but you didn’t tell me how to build self-discipline.

Why do I sometimes feel sad when the prices goes down?

I lost my money in the stock market. It's really painful and I need help.

No, whenever I check the prices and find them the same I feel sad.

I just can't wait to get my money back!

I didn't find my question here.

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