Your guide to investing psychology

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3 Minutes Read

What it is, why it matters, and three biases to be aware of. 

Behavioural Finance 

Do investors make decisions based on logic or emotion? There are two schools of thought. Historically, economic theorists have seen investors as 100% logical by gathering all the information they need to make rational decisions. Known as Traditional Finance Theory, this was the dominant way of interpreting financial markets for centuries. 

But in the ‘70s, psychologists Amos Tversky and Daniel Kahneman began studying how people respond to risk. They found that emotions, biases and flawed thinking can cause us to make decisions that aren’t completely rational. In the 1980s, Richard Thaler continued this research, and ultimately founded a new field of study that combined economics and psychology: Behavioural Finance

Sure, it might be great (from an investing perspective) if people acted like computers, with actions that were calculated with 100% logic and 0% emotion – but the field of Behavioural Finance says that this just isn’t the case. Maybe learning how psychology influences our financial decision-making can help us take back some control.

 

Anchoring Bias

Would you buy a pair of shoes for $1200? What if they were on sale for $400? 

Ok, rewind. Let’s say I mentioned a pair of $35 shoes first, before bringing up the $400 pair. Would you see the value of the $400 shoes differently? Probably.

This is a phenomenon called ‘anchoring bias,’ which theorises that some information (often the information we receive first) can stick in our mind and impact our decision-making in a big way. Anchoring was first referenced in a 1958 study by Muzafer Sherif, Daniel Taub, and Carl Hovland, and the field of Behavioural Finance has since adopted the term in relation to investing.

Here’s an example: the price of a stock when you first bought it can seriously influence your perception of its value. Let’s say an investor buys a stock for $200. That price can become an anchor in their mind, causing them to think of the stock as always being worth $200. Because of this anchor, they might decide to hold onto the stock even when evidence suggests its value has dropped, or they might decide to purchase additional shares of the same stock for up to $200, regardless of its performance over time. In other words, the anchor of $200 can affect the investor’s decision making, even if they have access to more useful or relevant data about the best move to make.

Sometimes trusting your gut is a good thing. But it’s also smart to ask yourself how you came to conclusions that just “feel” right – like your sense of how much something is worth.

 

Overconfidence Bias

Do you secretly consider yourself to be especially skilled and intelligent? Be honest. If so, you aren’t alone – psychologists say that it’s pretty common to think of yourself as being better at certain things than you actually are. For example, in a 1981 study on driver competence by Ola Svenson, 93% of participants described themselves as above-average drivers. This effect is called “overconfidence bias” – and it can impact your investing decisions. 

Researchers have some theories about where overconfidence bias comes from. They found that positive memories tend to be stronger than negative ones – so we often think about all of the successful investments we made, forgetting about those that didn’t quite work out. We also might remember making more money on investments than we actually did. Overconfidence can cause us to take risks while investing – like we might think we’re extra amazing at timing markets, so we take a chance on trying to buy and sell stocks more frequently, even though we don’t actually have a great track record with this strategy. Or, we might go all-in on a risky stock because we think we have amazing intuition for which stocks are about to become super valuable – again, forgetting about the times our investments actually resulted in a loss. Interestingly, overconfidence can also make us extra susceptible to other kinds of illogical thinking, like anchoring bias. 

Experts say the best way to combat overconfidence is to take time to learn from your losses (not just celebrate your wins) and to focus on the facts when making decisions.

Have you ever caught yourself falling into the overconfidence trap?

 

Loss Aversion Bias

Let’s play heads or tails. Tails – you lose $10. Heads – you gain $10. Worth the risk?

This is a scenario posed by economist Daniel Kahneman. Surprisingly, the students who responded to Kahneman felt like they needed to have a chance of winning at least $20 in order to justify the risk of losing $10. 

The reason behind this thinking is an emotional bias called loss aversion. Essentially, it hurts more to lose than it feels good to win so people will put more effort into not losing than they dedicate to winning. 

Now, loss aversion might sound like a good thing. Of course you don’t want to lose money on your investments! But, because loss aversion isn’t entirely logical, it can actually get in the way of your investment strategy.

Let’s say you invest $200 in a stock. It drops in value, and you lose $50. You have the option to sell now, and accept that $50 loss, or keep the stock in hopes of eventually recovering your investment. 

The fear of accepting the loss (because ouch!) might make you hold onto the investment, even if it’s clear that it’s just going to keep going down in value. Similarly, fear of losing money can cause you to avoid any risky investments at all – even ones that are potentially rewarding.

What should you do? Next time you’re presented with risk, think about how big the potential loss feels compared to the potential gain – and ask yourself whether this perception is affecting your judgment. 

Flahmingo Team

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