Introduction

Several variables influence stock prices in the short term, but all too often, it becomes a psychological game. Fundamental and Technical analysis can provide a foundation for your investment decisions; however, emotion can hinder the effectiveness of rational thinking. Therefore, it is crucial to comprehend investor psychology to keep emotions from interfering with our investment choices. What is investor psychology?

Definition of Investor Psychology

Investor Psychology is the study of how investors behave in response to the information they are presented with, based on their own personal views and beliefs. As Benjamin Graham once said: The investor’s chief problem and even his worst enemy, is likely to be himself. Thus, the study of investor psychology is focused on how investors allow their emotions to bias their decision-making process.

The Importance of Investing Psychology

When it comes to money and investing, the first thing that people would think of is which stock makes me the most money. However, investment success does not begin with our portfolio. Investor behavior has a much greater impact on our financial outcome. Most people disregard this fact and unintentionally allow our emotions to interfere with our investment choices. Irrational investment decisions are often driven by emotions such as fear, greed, pride, ego, or denial. In times of volatility, large market swings can trigger these emotions, further heightening the psychological state of investors and leading to a more rapid pace of market acceleration or deceleration.

We all assume we are rational human beings. However, our brains are innately programmed in a way that our emotional brains are bigger and more powerful than our rational brains. This helps to explain why investors might be tempted to follow crowd psychology, taking part in bubbles due to states of euphoria.

Tulips Mania, the South Sea Bubble and the Wall Street Crash of 1929 are just some of the many examples of market bubbles that illustrate market irrationality. Animal spirit - fear and greed - drives the financial market. The market makes mistakes and investor psychology plays a role in setting prices.

Stock prices deviate from their underlying value significantly when investors are over -optimistic or over-pessimistic, leading to increased volatility. This volatility is usually followed by the emotion of FOMO or fear and greed that could trigger impulsive action, ending up hurting investors’ bottom line.

Once one acknowledges investor psychology on a personal and collective level, the investor should embrace the positive psychological factors and dismiss the negative psychological factors to achieve investment success.

How to manage Psychology in investing

1. Develop a plan, and prepare for the worst before it happens.

The stock market is a roller coaster ride, so develop your plan based on your investing needs to make your ride smoother. An investing plan is a guide for investors that should outline the conditions or criteria for buy and sell decisions, and whether to enter or exit the position at any point in time. It is important for investors to stick to the plan and remain disciplined in executing the investing strategy following the initial plan.

2. Following your plan

Having a plan and adhering to that plan are two entirely different things when your investment return starts going against you. Emotion takes over when losses begin to sting. So, stick to your initial plan as it gives you a guideline to react to a situation that will help remove emotion from the equation.

3. Recognising biases and avoiding repeating past mistakes is crucial.

Emotions always play a part, and it is essential to be aware of them or else they will cloud your judgment during periods of instability and lead to rash decisions.

The cycle of investor psychology

As with economic cycles, investor behaviour usually conforms to a series of patterns and cycles. The pictures above give a rough idea of the psychology behind market cycles. They depict the range of emotions experienced by investors at different stages of the stock cycle, from optimism or enthusiasm to desperation or panic. It's just circular things that happen.

Bottom Line

Investing is more of an art and science than empirical science. Therefore, to be prosperous in investing, it would be helpful to comprehend our psychology/investing behaviours. This would provide us with a greater understanding of the root of the issue and what causes it. Although, the fundamental and technical charts are vital too. Learning from our mistakes throughout life will enable us to stay on course with our investment strategy and make the journey of investing longer.

What is most crucial, investors need to adhere to their investment strategy and be disciplined during times of volatility. To obtain investment success, investors must stop themselves from succumbing to panic. History has a way of repeating itself, and eventually, the market will rebound and patient investors will be rewarded.

Author

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This article is written by Dyce Lim, Research Analyst

Dyce is a research analyst in TED Optimus, tasked with researching and performing analysis on companies. She holds a Bachelor of Science in Financial Analysis Degree from Sunway University. During her time at Sunway University, She has participated in the CFA Research Challenge 2019/2020 and won second runner-up in the event. She is also a CFA Level 2 candidate. She is an in-house author of TED Optimus.