Over my 25 years of providing investment advice I’ve found it fascinating observing the psychology of investors. Why do people invest their savings in the first place and why do people make particular investment decisions?
People seek to invest in order to earn a greater return on their savings than bank interest rates. The best way to make money from an investment is to buy at a low price and sell at a higher price and then do it again.
This sounds simple but our brains are wired for survival within a tribe, which does not lend well to the long-term discipline of investing. We all operate with biases that make it difficult for us to invest well.
Below are only two of the psychological barriers to investing:
1. Herd mentality
We follow the crowd or those around us. We listen to those who we interact with even if they have no expertise or special insight.
When I was on the dealing floor every broker looked for acceptance or affirmation of their latest trading tip. Its feels better to be wrong together, then to separate yourself from the herd and potentially be right (or wrong) all alone.
Sometimes going with the majority is the right way to go but you need to be aware of ‘crowd think’. We all crave social acceptance. It’s good to be part of the tribe and in the past fitting in with the tribe meant better chances of survival.
When investing, stocks are typically at their cheapest when the herd is selling. Do you follow the herd or do you stop and analyse the facts before you decide whether the herd is right or wrong (potentially overreacting to the bad news)? If they are wrong, buying now when prices are low will reward you when the herd eventually changes its mind.
2. Loss aversion bias
The research of two psychologists, Kahnemann and Tversky, (written about well in “The Undoing Project” by Michael Lewis) is that people feel losses more acutely than gains. Markets are volatile and in the short-term losses are very common. The markets go up as well as down and when you lose you feel the pain twice as much as the joy you feel when they are going up.
Throughout my career I have seen this loss aversion bias play out negatively for clients. A typical scenario is investors evaluating their stock portfolio are more likely to want to sell stocks that have increased in value, rather than those that have gone down because it hurts to take a loss.
Unfortunately, this means people end up holding on to the poorest stocks waiting for the stock price to recover enough to ‘just break even’.
Quite often I find myself as a psychological leveller for clients, encouraging them to continue to hold investments when the market is down and the crowd is fearful and reassuring them things will get better. But also when markets are booming, telling them this won’t last forever, and that now is the time to be cautious and build up some cash.
We all have biases, however recognising them is the first step to managing them. The next step is to have a strong investment philosophy to assist you to overcome your inbuilt bias and become a more effective investor.
Your advisor can help you be aware of your biases, talk you through your reactions to them and, if required, take the investment decision out of your hands.
For investment advice, contact Allan Hanson of arcinvest.
For further reading on Behavioural investing see the following books:
Fooled by Randomness: The Hidden role of Chance in Life and in the Markets by Nassim Nicholas Taleb
Thinking, Fast and Slow by Daniel Kahneman
The Undoing Project: A Friendship that Changed the World by Michael Lewis