Stock investing and psychology

Are investing and psychology inter-related? How do they impact our investment habits? You will be surprised with the answer

  • TweetTweet
  • Share on Google+Google+
  • LinkedinLinkedin
  • FacebookShare

If you thought that investing is all about analysis, you will be surprised to know that your own psychology is as much, if not more, important when it comes to investing.

You may still wonder what psychology has to do with the stock market. Psychology is the study of mind and behaviour. It is especially important in the stock market because market moves tend to be erratic and often irrational. If you don't understand the psychology behind what causes them, you may be dragged along with them. This may hamper your chances of making money in the market.

Get updates from Value Research in your inbox

A popular way of studying stock-market psychology is by studying the many thinking biases that investors suffer from. A bias is a faulty way of thinking that we have grown accustomed to. Take this instinct called loss aversion for instance. Investors react to losses more intensely than they react to gains. So the joy of making a gain of Rs 10,000 is not as intense as the pain of incurring a loss of Rs 2,000. This is what makes investors sell in panic if the stock market goes down. As more and more investors join the frenzy, a crash happens.

Consider the confirmation and availability biases now. While researching a company, investors tend to focus on data and information which are easily available to them. This results in the availability bias. Instead of looking for data which are not easily available, investors base their investment thesis on the available data. What's more, having developed a viewpoint, they ardently focus on the information that confirms their viewpoint, rejecting any conflicting information and viewpoints. These two biases result in incomplete research, which may come to haunt back later.

Herd behaviour is often seen in the stock market. This causes particular sectors or stocks to become overpriced. The latest market fad is IPOs. In the ongoing booming market, many IPOs have given good listing gains. This has attracted many more investors to the stock market, who call themselves 'IPO investors'. Seeing this euphoria, more and more companies are making a beeline to the list. Herd behaviour often leads to 'market stampedes', which leave investors bruised and wounded.

The iconic investor and Warren Buffett's partner Charlie Munger has talked about the so called liking/loving tendency. In investing, it means that investors frequently fall in love with their stocks. Because they have researched them, held onto them for a long time and perhaps are making paper profits on them, they stop being objective about them. They tend to ignore any adverse business development. This eventually results in wealth destruction. But even after wealth destruction, the loving tendency causes investors to stay invested in hope of a recovery.

These biases are just a few among the many more that exist. A number of books are available on this subject. Here are a couple of them: Misbehaving by Richard Thaler, Thinking, Fast and Slow by Daniel Kahneman, The Art of Thinking Clearly by Rolf Dobelli. A classic on this subject is Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay. A recently released one is Dollars and Sense by Dan Ariely, Jeff Kreisler.

These books will not only throw light on investor psychology but also make you more rational about money, while also improving your overall thinking skills.

comments powered by Disqus