Psychology of Investing
This page has been set up as a blog with new material being added each Monday. You will see information about common psychological factors that influence the behavior of share investors. You will also see tips and suggestions on the psychology of investing. Much of what you will see in this blog comes directly from Dr. Abramson's doctoral research. Feel free to bookmark this page so that you can return to it on a regular basis. For more information on the psychological side of investing, you can email Dr. Abramson requesting your own complimentary subscription to Money Quarters. And for now, scroll down to learn about:
- Invest for the lifestyle (uploaded 27th May 2019).
- How to Know if You Have a Profitable Investment (uploaded 4th March 2019).
- Keeping Your Cool (uploaded 10th June 2019).
- Trading and Investing - Are they Forms of Gambling? (uploaded 4th March 2019).
- Bubbles and Crashes (uploaded 11th March 2019).
- Investor Overconfidence (uploaded 11th March 2019).
- Investor Overreaction (uploaded 18th March 2019).
- Appetite for Financial Risk (uploaded 1st April 2019).
- Information and the Media (uploaded 8th April 2019).
- The January and July Effects (uploaded 15th April 2019).
- Fight - Flight - Freeze (uploaded 25th March 2019).
- Fight - Flight - Freeze in the Share Market (uploaded 20th May 2019).
- Psychological Biases (uploaded 22nd April 2019).
- Psychological Biases - Familiarity Bias (uploaded 29th April 2019).
- Psychological Biases - Disposition and Endowment Effects (uploaded 6th May 2019).
- Psychological Biases - Status Quo Bias (uploaded 13th May 2019).
- Useful Mindset for the Share Investor (uploaded 3rd June 2019).
- Useful Resources (uploaded 17th June 2019).
Invest for the Lifestyle
When we invest for ourselves, we are ultimately investing as a means of maintaining our current lifestyle throughout our wise years. While we are working, we are in an ideal position to build wealth for our wise years. Yet, more often than not, we find our expenses expand to fill the income available. And, then some. So, what can we do to build wealth for our wise years?
It is useful to begin by articulating your lifestyle goals and objectives for your wise years. If you have a life partner, this is a task best discussed with your partner. You may also want to visit your current lifestyle and note what is important (and that you want to maintain), and what is not so important (that can be dropped). Once decided, keep your lifestyle goals at the forefront of your mind with each investment decision you make. You also need to keep your lifestyle goals at the forefront of your mind through market gyrations (property, shares, or whatever else you might choose to invest in).
From there, it simply a matter of obtaining the necessary knowledge and expertise. Some of this knowledge may come to you as you research potential investments. The balance may be obtained through the services of a shrewd accountant.
At the end of the day, we can plan our investments with our lifestyle goals and objectives in mind. And, we can ultimately enjoy the investment results we get.
How to Know if You Have a Profitable Investment
Have you ever invested in shares in a particular company and watched the share price fall after you invested? Ouch! Have you held on for years afterwards in the hope that the share price will recover? And, you are still waiting?
Perhaps you are so disappointed with your early investment choices that you have yet to make any further share investments. Good money after bad? If so, you may regard investing as just another form of gambling, but is it?
You may have seen something that the rest of the share market has yet to see. If so, you have taken a big risk that may take many years to bear fruit. The risk that you have taken may be much greater than you realise. If so, you may have placed more capital in the share investment than you are actually prepared to lose. It is only natural to feel frustration and disappointment when you see the share price continually fall from your initial purchase price.
Perhaps you have recognised a great new investment opportunity that other share investors have also recognised, but acted once everyone else has already invested in the asset and are now seeking to capitalise their gains.
Perhaps you are the only one to recognise this investment opportunity but there are factors you had not considered (both internal to the company and external). If so, it may be a factor of where you source your information, and the range of information sources you utilise.
Yet, it is possible to make share investments that consistently grow over time, giving you ongoing dividend income and/or capital growth from your investments. The secret is all psychology: Yours and those of groups of investor who operate on masse with one another (such as mum-and-dad investors or institutional investors).
Keeping Your Cool
What if you can see a profitable investment opportunity that no-one else yet recognises? You may feel like a fool when fellow investors are running in the opposite direction to the one you think you should take. Perhaps you wonder why no-one else sees what you do. Until they do. Then, you can wipe your brow with relief as the unrealised (or realised) capital gains roll in. How many of us have the fortitude to wait for that opportunity to reap its rewards. Nice if you can put a huge pile of money into that opportunity and later watch an even bigger pile of money rolling in.
As your investment skills grow, you are likely to identify a profitable investment opportunity that no-one else does. You may recognise the opportunity because of your unique set of knowledge and skills (outside the world of finance), knowledge of the industry to which the share investment belongs as well as skills in valuing shares. If/when this happens, you may be in a position to invest in that opportunity; an investment that may run contrary to the actions of other investors. This is where fortitude is required. If you have done your sums right, you may have much to gain by so doing. If wrong, you will have added to your financial education, enabling you to hone future investment decisions. With this in mind, you are well-advised to only invest what you are willing to lose. You will find that you sleep better at nights by so doing.
And for the rest, you can keep your cool by practising the relaxation techniques you enjoy using (such as deep breathing, mindfulness, yoga, meditation or self-hypnosis). Keep your analysis and reasoning at the forefront of your mind. Remind yourself often of why you have taken the steps that you have. And, wait.
Not every investment opportunity you identify will pan out the way you expect. Some may do better than you anticipate. Others worse. Others may prove not to be a good investment at all. Time will tell. But, with each investment opportunity you undertake, you can be guaranteed of learning something new about the investment world. And, you will have invested in your biggest asset: You. So do your research, form your conclusions and invest on the strength of your conclusions. Be prepared to be wrong - there are other investors at play here. Be prepared to wait to be proven right, or wrong. And, learn from each investment (the good, the bad and the ugly). By following your own wisdom, you will ultimately do well.
Trading and Investing - Are they Forms of Gambling?
I have often been asked whether trading and investing are forms of gambling. Trading and investing are different activities with different time horizons. Traders may buy shares that are rising in value with the intent on selling them for a capital gain over a short period of time (such as 24 or 48 hours). However, you have to time it so that you get out before the direction of trading changes. This can be a gamble.
Investing involves researching shares of a particular company to identify whether or not they are worthwhile to buy with a view to holding 3-5 years, perhaps indefinitely. As an investor, you may consider what the company behind the shares does and how they do what they do. If you like the what/how, you may then consider the pricing of its shares. The underlying value of a company's shares may differ from how much you can buy/sell them for. When you know how much a company's shares are genuinely worth, you have taken much of the 'gamble' out of the investing equation. The better you are at valuing shares, the better you will be at buying shares at a fair, or discounted, price. And, when you buy well, you can ultimately sell well.
Bubbles and Crashes
There have been times in the history of the share market where share prices have risen higher or fallen lower than was called for (eg., tulip bubble, internet bubble and the great depression). In each case, investors recognised a great new investment opportunity. They all wanted to ride the wave up (and enjoy nice, healthy capital gains). But it gets to a point where there are no new buyers to buy from you and existing investors are ready to capitalise their gains. When that happens, the price of that great new investment opportunity starts to reverse and then fall to pre-bubble prices. In the case of the great depression, the whole market collapsed. Even shares in valuable companies became highly discounted to what they were really worth. Shares in speculative companies became worthless.
Why does this continue to happen over time? Perhaps because investors and traders 'there' for one bubble (and its subsequent collapse), were financially burnt, so much so that they have no interest in the next one. In some cases, they were no longer alive to warn their children or grandchildren about their experiences. Each generation of investors are left to learn this lesson for themselves - unless they read or listen to some sound financial training provided by independent professionals, as is the case with my three talks. At the end of the day, we can focus on investing in shares that have a strong/solid financial base and for which we would be comfortable to hold indefinitely.
Benjamin Graham was one of the first to recognise the volatility we see in share markets. He coined the term Mr. Market to personify share market behavior. [Graham's book was initially published in 1949 - a time when most investors were men. The salutation of Mr. was thus very apt for the times]. Graham recognised that Mr. Market may act rationally for most of the time, but that there would be periods where Mr. Market would become euphoric and seek to invest in shares, no matter what the price. Graham also recognised that there would be other times when Mr. Market would become despondent or fearful and would try to sell out of his holdings, no matter how little he might get for his holdings. Graham advised investors to ignore the gyrations of the share market and only approach Mr. Market when we want to buy or sell shares. He also advised investors to buy when Mr. Market is keen to sell and sell when Mr. Market is keen to buy. In so doing, we can buy well to sell well. Warren Buffett has used a variant on Graham's approach, with consistently remarkable results.
The personification of Mr. Market begs the question of what might be going on behind the extremes of euphoria and fear within Mr. Market's behavior. This section introduces overconfidence as one of those qualities behind the behavior of Mr. Market. I will speak more about overconfidence over the next few weeks as well as introduce two more qualities that may help explain Mr. Market's behaviour.
Share investors can sit somewhere on a continuum of confidence; with one end of the continuum representing a lack confidence (i.e., underconfidence) while the other end of the continuum representing overconfidence. The middle of the same continuum represents a healthy level of confidence. Underconfident investors may invest in blue chip investments with the intention of holding them for the long-term. Overconfident investors may make more risky investment decisions and turn over their share investments more quickly. Past research has shown that overconfident investors do trade more and that those trades have a deleterious effect on portfolio wealth. That same past research has also found that men trade more than women and that the difference in overconfidence is even more pronounced for single men than it is for married men.
When you look at the share market as a whole, you can see that there are times when shares in certain companies are avoided i.e., losers while shares in other companies are highly sought-after, i.e., winners. What is interesting is that academic research has consistently shown losers outperform winners for up to five years. Investors acting in tandem appear to overreact. It seems the Grahamian concept of buying when Mr. Market is fearful and selling when Mr. Market is euphoric has its wisdom.
What is also interesting is that individual and institutional investors can seem to be acting in tandem with one another to the point that there is an upward pull on share prices at times of euphoria and a downward push on share prices at times of fear. To outside observers (and indeed, the academic world), it can seem as if investors are acting irrationally. I prefer the term human. More about in the next section.
Appetite for Financial Risk
Just as our position along a continuum of confidence can vary, so too, can our position along a continuum of risk appetite. The greater the appetite for financial risk, the riskier the share investments we are prepared to invest in. The lower our appetite for financial risk, the more we are inclined to make conservative share investments.
Irrespective of where we sit along the continuum of risk appetite, it would appear that we are more inclined to acept the risk while share prices are increasing (and congratulate ourselves for excellent share selection). However, we are not prepared to accept the same degree of risk when share prices are falling. We often find ourselves dramatically changing our share selection at such times or pulling out of the share market all together.
This is why it becomes very important to understand the true degree of risk we are taking on in our share investments. It may mean making more conservative decisions than we might think we want in good economic times so that we are comfortable riding out the poor economic times. Confidently.
Information and Social Herding
How does it happen that investors overreact? How do they get to overreact in tandem with other investors? The academic literature refer to social herding, where investors have a tendency to follow the crowd. There may be a sense of safety in being where everyone else is, when they are. There is research to suggest that social herding even occurs with stock brokers, where they all follow one another in the recommendations that they make.
But, there is more. Decisions are made on information. And, investors get their information from the same sources: The media (e.g., print, radio, T.V.). If you are accessing the same media at the same time as fellow investors, you will be reaching similar decisions, and taking similar steps, at the same time as your fellow investors. When that happens, the market as a whole will appear to be operating as one big social herd.
So, what does this mean for us as investors? Perhaps use other means of keeping yourself informed about your investments. If you are accessing the same media as fellow investors, consider how other investors might respond to this information before deciding what steps to take on your own investments.
The January and July Effects
The January Effect is a phenomenon where share prices dip over the last few days in December of a calendar year and bounce back in the early days of January. The January Effect was first observed in the U.S. where the financial year aligns with the calendar year but it has been observed in other countries, not just those where the tax year aligns with the calendar year. In Australia, there is both a January and July effect. The January Effect has been attributed to tax-loss selling and portfolio rebalancing. It has also been attributed to a pooling of funds from share sales with those from other sources (including holiday bonuses) before making any fresh purchases in the new year.
Fight - Flight - Freeze
Our brains have been wired to respond to life-threatening events. If we see a hungry lion hungrily licking its lips while looking at us, we are not going to stop cuddle it or stroke its fur. The moment we sense the presence of that hungry lion we are running. We may even be running for our lives before we consciously realise that it was a lion we saw. If it is a different kind of animal we think we saw, we may choose to prepare ourselves to stay and fight.
This response is typical of fight/flight behaviour. It is triggered by a small area in our mid-brains known as the amygdala. The amygdala is often called our danger detector. The amygdala cannot distinguish between that which might literally kill us (such as a hungry lion) or something that might cause us distress (such as an angry boss or share market decline). The amygdala is able to evoke action before we are consciously aware of what is happening by flooding us with fear and anxiety. The amygdala will simultaneously slow down any digestive processes happening within the body and prepare our major muscle groups for fighting or fleeing. It may be only after we have begun running for our lives (literally or figuratively speaking), that our conscious minds may catch up with us and wonder what we are doing. By that time, we may have already taken action based on the levels of fear or anxiety coursing through our bodies.
It is interesting to note that the amygdala may also cause us to freeze in what it considers to be a life-threatening situation. You may have seen animals roll over and play dead when they are overwhelmed by a situation that could prove deadly for them. Many people seem to freeze when called upon to speak in public. While public speaking is not life-threatening, we may feel as if our whole life depends on how well we perform on the stage. If we find ourselves freezing, we could find ourselves unable to express our thoughts or ideas. Indeed, we may even find ourselves feeling so overwhelmed that words are just not available to us. What we may not be aware of is that our breathing becomes quite shallow when we freeze, so much so that we are not fully oxygenating our bodies.
So, what should we do if we find ourselves flooded with emotions of fear or anxiety? If we find ourselves metaphorically running for our lives, we need to stop and remind ourselves that, chances are, we are not being faced with a hungry lion. We need to give our conscious minds a chance to catch up. And, we can do that by slowing ourselves down. Breathe. Breathe deeply. Ask ourselves (a) what is actually going on; (b) what would we like to have happen; and (c) how might we best have that happen.
If we metaphorically find ourselves freezing, so much so that we are too nervous to articulate our thoughts or ideas, we need to remind ourselves that our audience is not made up of hungry lions. Once again, we need to slow ourselves down and ensure our whole body is properly oxygenated. We can best do that by breathing deeply (before, during and after the talk). We may also find it helpful to rehearse the talk (imaginally or in vivo) until the talk unfolds the way we want it to. You will also find it helpful to visualise a positive progression and outcome of your talk. Finally, it is often helpful to do a full body stretch, standing as tall as you can before you walk up to the podium. Doing so will give you an added boost of much-needed confidence.
For many of us, these strategies may be all you need to manage the levels of fear and anxiety evoked by our amygdalae. However, if you find these strategies insufficient to help you manage the level of fear and anxiety, perhaps it is time to book an appointment for hypnotherapy with Dr. Abramson.
Fight - Flight - Freeze in the Share Market
When Cannon developed his concept of fight - flight behaviour, he noted that this behaviour can occur in share markets. When investors act in unison to sell their shares in a particular company, they are 'fleeing' in fear of losing their capital.
Part of the reason investors can act in unison in today's share markets may, in turn, reflect the ready access to news (print and social media) in a way that previous generations of investors did not have. If a company has news to release, it can be disseminated to investors quickly and egalitarianally. With investors receiving (and digesting) the news at approximately the same time, they are ready to act at the same time as other investors. If one piece of news led investors to conclude that they should sell their holding in a particular company, that news item creates downward pressure on the share price. And, the more investors wanting to sell their holdings, the greater the downward pressure on that company's share price. Over time, the downward pressure can act to fuel other investors into selling their holding. This trend will continue until there is no-one left wanting to sell their shares in the same company. Then the downward momentum fizzles out and starts to reverse with new buyers hunting up a bargain. In some cases, the news item about the company is significant to the company's business operations (and the subject of that news item may have a detrimental effect on the company's bottom line). On other occasions, the news item is insignificant and the company will continue to do business just as strongly as ever.
So, what should we do as investors when faced with such news about one or other of our investments? Begin by reviewing your own investment strategy and protocol. You will want to keep your investment strategy and protocols at the forefront of your mind. If your strategy needs tweaking, by all means, do so. However, if it is sound, you want to base your decisions within the frame of your investment strategy and protocols.
You can then continue by doing your own independent research on the company (management team and financial position). You will want to assess to what degree the news item is insignificant or likely to have a major (negative) impact on the company's bottom line. With your own analysis to hand, and your own investment strategy at the forefront of your mind, you are then in a position to make a more reasoned/considered decision on this particular company. You may, for instance, go with the direction of the market. Or, you may end up acting contrarially. Each time you utilise these two steps in your investment decision-making, you will find that you are honing your investment skills (for the betterment of your long-term wealth).
It is not just strong emotions (such as fear, anxiety, greed or euphoria) that can influence our behaviour in the share market. Our investment decisions can be influenced by psychological biases. Psychological biases reflect faulty thinking at some level of analysis. Watch this space over the next few weeks to find out about the different types of psychological biases and why they matter.
Anchoring: Anchoring is a psychological bias where investors tend to evaluate their investments in terms of a set point, usually the price point at which the investor purchased his/her shares. This might seem like a sensible thing to do. You want to know how your share portfolio is tracking and whether or not your investments are profitable. However, this bias means that investors tend to consider investments from the vantage point of their initial anchor, while downplaying relevant information about the company, industry it operates in and other factors that may inform investment decisions.
Disposition Effect: The Disposition Effect occurs when investors capitalise gains too quickly and hold onto losing stocks too long. In so doing, investors may miss out on more of the potential gains while potentially increasing the extent of capital losses down the track.
Endowment Effect: The Endowment Effect occurs when investors expect the same shares to be sold for more if they already own those shares than they would be prepared to buy those same shares if they did not own the shares. This may mean that investors do not end up buying shares (because they cannot get it cheap enough) while missing out on capital gains (because the shares are not currently attracting a sufficiently high price in the share market).
Familiarity Bias: The Familiarity Bias occurs when we prefer to invest in local companies over national or international ones, perhaps investing in companies for whom we are also a customer. Investors who do so, tend to have a low risk appetite than those who will also include national and international companies in their investment portfolios. Investing in local companies may not seem like a problem per se, however, such investments may lead to poorer investment returns in economic downturns.
Mental Accounting: Mental Accounting is a psychological bias where investors mentally establish separate accounts, with each account serving a different purpose. For instance, one account might be set up for day-to-day needs; another for day-trading; and a third for long-term investing. On the surface, this approach may seem like a good money-management technique. However, the maintenance of several separate accounts may also mean that there is also no fluidity between accounts when needed. Moreover, if an investor purchased several parcels of shares (accounts) within the same company, the investor may expect each parcel of shares (account) to be profitable before being sold for capital gain (as opposed to selling the combined parcels for an overall gain).
Representative Bias: Representative Bias occurs when we treat one thing as a representation of another. Thus, the shares of the company are seen as no different from the publicly-listed company itself. However, the company may demonstrate a different financial performance than that of its share prices.
Status Quo Bias: There are many other psychological biases. However, the last one I want to talk about in this blog is the status quo bias. As the name suggests, investors who are subject to this bias have a tendency to stay with the status quo. By staying with their current portfolio makeup, investors may amplify potential losses or miss out on more lucrative investment opportunities.
Useful Mindset for the Share Investor
Academic research asked the question of whether or not share investors were irrational. I prefer to describe investors as very human. But whatever term you use, it is clear that certain investor mindsets are more helpful than others. Here are four factors to take on-board when developing your own mindset around investing:
1. Keep cool: It is important to keep cool, calm and collected when considering your investment decisions. You also need to take a long-term perspective, rather than react to current share market activities. After all, if you wait long enough, the market will turn back on itself and head off in the opposite direction.
2. Do not get too confident in your own abilities: We tend to make the greatest investment mistakes when we think we cannot go wrong. We also tend to trade too much when we are overconfident and that extra trading tends to weaken our investment returns.
3. Get a financial education: Your financial education should include short courses or books on fundamental analysis so that you know how to analyse company accounts. You will hone your education each time you examine potential share investments, make a judgement as to whether the company is a good one, as well as whether the company's shares are available at a fair price.
4. Do not follow the investment crowd: Once you have made your share selections, you should not need to touch them unless and until you have further funds to invest. If you chop and change your investment strategy so as to follow the investment crowd, you may find that you are investing in fad-like investments; investments that may not hold their value over time. Even if the investments do not turn out to be fads, you may find that by the time you have found out about them, you are too late to purchase those investments at a fair price. It takes a lot of internal strength to be able to invest independently of the direction of the investment crowd. You will find this factor much easier to incorporate into your investment mindset once you have mastered the first three factors.
At the end of the day, you can develop and hone your own investment mindset; one that will ultimately serve your portfolio wealth well.
- Reading: (1) Books on Warren Buffet; (2) Benjamin Graham's The Intelligent Investor.
- Learning about share investing: Australian Stock Exchange online short courses.
- You can also attend Dr. Abramson's seminars on the Psychology of Money and the Psychology of Investing. See our Eventbrite page or email Dr. Rachel Abramson for details.
Our newsletter, Money Quarters, provides articles, quick tips, food for thought to help you reach your full potential: Money-wise. If you would like your own complimentary subscription to this newsletter, feel free to email your request to Dr. Rachel Abramson . You can also follow Dr. Abramson on Facebook or Twitter.
Disclaimer: The ideas expressed in this blog take a psychological perspective on share investing. Similarly, the ideas expressed in the Psychology of Money blog take a psychological perspective on money and finance. The ideas expressed in both blogs should not be construed as financial advice, but instead, provide food for thought on how your own psychology may have an impact on your wealth (short-term, medium-term and long-term). You would be well-served to see a shrewd accountant if you would like financial advice pertaining to your own circumstances. You can book an appointment with us, if you would like advice managing your own psychology with money or investing.