The role that psychology plays in investing

In most economics textbooks, it is taught that markets and their participants behave rationally. However, this is a fundamentally flawed idea, because when making decisions around anything, there’s an element of psychology and subjectivity involved.

If markets were perfectly rational, there would be no market noise, no by-the-hour fluctuations in prices, and likely no speculative bubbles either. If we consider the recent influx of money into the BBBY stock as part of a WallStreetBets community project, followed by its crash, the price was anything but rational.

This article seeks to explore the key psychological biases that interfere with our investments and the threats they pose.

5 Major Psychological Biases When Investing

Risk-taking when losing, risk-averse when winning

If you had a double-your-money betting opportunity with a heads/tails coin, but the odds on heads were 60% instead of 50%, you're clearly getting fantastic Expected Value. Not taking this bet would show that you’re being risk-averse.

Studies show that individuals become more risk-seeking when it comes to losing money, but risk-taking when it comes to gaining money. So, people would rather take a guaranteed £25 than have a 25% chance of winning £100, despite the Expected Value being the same. But when framed as a loss, people would rather have a 75% chance of losing £100 than a guaranteed loss of £75.

Risk aversions when winning doesn’t sound like the most dangerous bias, but it means missing out on good opportunities. Risk-taking when losing, though, can make it difficult for people to walk away from the table when losing and also introduces an element of Sunk Cost Fallacy.

How to fight it

First and foremost, we should become better at assessing Expected Value. Secondly, the previously linked study shows that this bias substantially decreases when someone else is in charge of that money. Therefore, a wealth manager will not fall victim to this bias when investing for you.

Overconfidence

A big issue among particularly new investors is overconfidence. Overestimating our abilities to make astute investments is not only common, but a cause of putting too much faith in high-risk investments. For example, many people believe "their" crypto coin is the one, but they can't all go on to be a success. By definition, many, or most, of that overconfidence is unjustified.

How to fight it

Keep in mind that we cannot predict the market better than anyone else; 95% of finance professionals cannot do it.

Confirmation bias

As we build our portfolio, it begins to reflect our beliefs around the world. Holding Nvidia, Meta, and Ethereum likely indicates that you're a big believer in the future of AI and the MetaVerse economy. The danger is that you may consume news and opinion through this lens, and skim over any evidence that goes against this narrative.

A common example is believing there will be a crash. News sites get more clicks, thus revenue, for extreme headlines. It's very easy to just read these headlines to confirm your beliefs surrounding an imminent crash, and not consume any positive news about the economy.

How to fight it

Follow a range of thinkers and communities on social media, not just those that agree with you. And in some instances (long-term passive inventors) simply refrain from reading too much financial news.

Herding

Herding is essentially following the crowd, and it can explain momentum and inertia within market activity. It's the idea that once enough of the market takes action, others will follow. This is where the phrase "markets take the stairs up, and the elevator down" comes from.

This is also why consumer, investor, and business confidence are all so important to an economy. Mass-selling equities will cause further selling, because people don't want to be the one left holding the bag. Likewise, if an unknown crypto coin grew by 10,000% in the next few months, many would buy into it based on that fact alone. In the short term, belief in an investment can dictate its success more than its fundamentals.

How to fight it

This is a phenomenon that can help inform investments to a degree, as long as you understand it. But ultimately, asking if the investment is good value with good fundamentals can help avoid overpaying. Plus, knowing that a market is crashing because of herding can help you stick it out, thus avoiding panic selling.

Fear Of Missing Out

The fear of missing out is a growing psychological weakness that doesn't get much attention. It's growing, in part, because retailer investing is growing. With the rise of meme stocks and social media investing, it comes with a sense of missing out if you're late to the party.

Browsing WallStreetBets on Reddit can expose the dangers of FOMO when combined with herding. Many people invest lots of money into a crypto coin or meme stock because the community is growing the stock rapidly. But, they buy in too late just as the tide is turning.

How to fight it

Remember that the tide always does turn, because an asset built on hype will only garner short-term investors who are ready to flee the second the ship rocks. If an asset has made the headlines because of its eye-watering growth recently, it's likely too late to join the party. 

Can we ever be perfectly rational?

It’s clear that there are so many biases that they’re impossible to negate all of the time. But, what we can do, is set limitations within our strategy that doesn’t even allow us to make frequent, improvised judgements.

Intuitively, the more active we are when investing, the more prone we are to these biases. Therefore, having a long-term strategy that doesn’t require making constant judgement calls can mean setting it and forgetting it, which protects it from ourselves. Some people are simply adamant on a highly active investing strategy to try and beat the market, and, these people should consider building an algorithmic trading bot directed by pre-set rules. Pre-set rules, of course, are void of emotions and psychological bias.

Alternatively, we can use a wealth manager to keep us from making rash or blinded decisions. Studies show that psychological biases play a much bigger role when investing our own money, not someone else's. In that sense, the wealth manager will be an even better investor for you than they are for themselves.