Appreciating the Role of Human Psychology in Investment
We can all relate to that feeling of anticipation when we await results of the lottery, a winning horse or a bid at auction. The build-up of excitement, a sense of great expectation and suspense. It’s a heady mix of delight and dread.
These exact same feelings are also experienced by investors looking to get a sizeable return on their hard earned cash, particularly in light of the current uncertain economic climate. Investors experience highly variable emotional states ranging from optimism or enthusiasm to despondency or panic. These emotions and psychological states are further heightened during rapid phases of market acceleration or deceleration.
As such understanding and acknowledging these behaviours and responding to them effectively can not only enable an investor to approach financial objectives with a calm and rational approach, but it can also help to maximise the opportunities available to them.
Classical financial theory assumes that investors are rational. But a rational investor – one who makes decisions without any emotional interference – exists only in theory. In reality, every individual’s decisions and risk-taking behaviours are influenced by their own psychology, emotions and personal experience.
Human psychology has a major impact on investor behaviour. According to DALBAR, a leading research company, studies have suggested that it has a negative impact of around three percent on portfolio performance. That’s enough to double the initial investment over 20 years. This is known in the industry as ‘behavioural finance’ a concept within the ‘prospect theory’ developed in 1979 by American psychologist and economist Daniel Kahneman, winner of the 2002 Nobel Prize in Economics, in collaboration with psychologist Amos Tversky.
The principles of behavioural finance help explain why investors often make irrational and spontaneous decisions which don’t always have positive outcomes. These are:
- Loss aversion: expecting high returns with low risk.
- Narrow framing: making decisions without considering all implications.
- Anchoring: relating to familiar experiences, even when inappropriate.
- Mental accounting: taking undue risk in one area and avoiding rational risk in others.
- Diversification: Seeking to reduce risk by using different sources, giving no thought to how such sources interact.
- Herding: copying the behavior of others, even in the face of unfavorable outcomes.
- Regret: treating errors of commission more seriously than errors of omission.
- Media response: reacting to news without reasonable examination.
- Optimism: believing that only good things happen to ‘me’.
Applying psychology to finance can help investors reduce the impact of their emotions on investment decisions, improving gains and reducing losses. But how? It is a fairly complex situation and numerous external and internal factors can impact an investor’s decision. The most common factors however, holding investors back from seizing good opportunities are:
- Resistance to change –investors see any new development as an additional risk factor, even if it is positive.
- Regret aversion – investors restrain from taking action out of fear of making a mistake.
- Recency bias reflects the natural tendency to only look at recent market performance disregarding long-term trends.
Behavioural biases by investors in response to market peaks and troughs can also create a false sense of security or fear and each tend to increase the risks taken either to accumulate or to reduce their market diversification.
These are examples of excesses that expose investors to damage in the event of a trend reversal, in the first case, the investor loses an opportunity. In the second, they greatly increase their risks.
Savvy investors and asset managers will understand the importance of applying psychology to financial decisions. Recognising its influence and responding appropriately can help investors reduce the impact of their emotions on investment decisions, ultimately improving gains and reducing losses.