In order to create a winning investment strategy, it’s important to understand investor psychology. There are four driving forces: fear (which causes selling pressure), greed, optimism and pessimism.
Reliance on recent news highlights the effect of recency bias: we’re more likely to remember recent investments that performed well recently, or were publicised by the media. Recency essentially prevents us from learning from experience.
Experiential Bias
The stock market is often a very emotional arena, where investor emotions and biases can dramatically affect their decision making. Behavioural finance research has brought to light some of the potential psychological factors that influence investor decision-making processes.
Experiential bias occurs when investors are influenced by their own personal experiences in market trends, stock prices or anticipated events without considering all the relevant facts. Sharpening the focus of the first cause Online reputational mechanisms increase the pressure on bloggers, journalists and commentators to stay on target and avoid evaluating companies based on consumer biases. Additionally, experienced investors combat this cognitive quirk intuitively and by constantly searching for and appraising new information, especially the kind that runs counter to their own preconceived notions or beliefs.
Investor loss aversion, when losses carry a greater weight than equivalent gains, incentivises individuals to trim portfolio diversification levels and under-allocate capital to new investments. The herd mentality, stemming from investors’ penchant to blindly follow trends and chasing market momentum, can provoke volatile swings.
Familiarity Bias
Your familiarity with a type of investment can affect your decision processes – a cardiac surgeon might only want to invest in companies that are familiar to her, fogging her ability to see where growth will come from.
Familiarity bias leads to people extrapolating the past performance of an asset (eg, investing in a stock) so, if it has performed well historically, for example, then people will assume it will continue performing well. This is overconfidence bias.
Familiarity with the investments (eg, investing in one’s country, region or state, and with stocks of particular companies) is another illustration of the familiarity bias, contrary to the EMH, because investor willingness to diversify is hampered by the over-exposure to one’s own countries. The risk of capital losses will therefore increase. The sociologist Geert Hofstede’s theory of culture helped develop the notion of ‘time priorities’ as a decisive aspect in individuals’ attitudes towards risk-taking. His theories advanced a set of four dimensions on which cultural differences have been evidenced: power distance, individualism and masculinity.
Confirmation Bias
Confirmation bias often leads investors to hold on to investment premises and ignore or dismiss data that might disprove those preconceived notions and ultimately cause them to invest in something they shouldn’t, or to hang on to a losing investment too long. It could lead to bad investment choices.
Extrapolation bias (according to Nobel Laureate Daniel Kahneman in Penguin’s short book, Thinking, Fast and Slow) is another cognitive bias where we over-weight small pieces of information by giving them too much meaning. For example, if five flips of a coin have already come up heads, this piece of information makes us assume that heads being up next is now more probable.
Having endured a run of bad markets, this might tempt people to try to keep pace by taking excessive risks – slashing investment levels – and failing to diversify into safer investments, a move that will compromise returns.
Overconfidence Bias
One of the most typical behavioural factors in stock market investing is overconfidence bias. People tend to overestimate their abilities to forecast stock market trends, and make bad decisions as a consequence. Such irrationality often leads to poor investment returns when traders make trades more frequently.
Further adding to overconfidence biases, investors might also syphon off small scraps of information and incorrectly infer that whatever pattern mistakenly seems to crop up in these scraps is likely to continue into the future – leading them to be overzealous in their trading activities, for example by overestimating the probability that the next five coins tossed will each land heads.
Research on overconfidence bias when investing in the stock market draws on different branches of social sciences, including econometrics, finance, psychology and management. Investors are interesting not only because our decisions can affect them, but also because thinking scientists use them to study how cognitive biases affect our decision process.
Loss Aversion
In addition, investors suffer from the biases of loss aversion and the sunk-cost fallacy. People who suffer from loss aversion evaluate warmed-over losses differently from cold cash gains, so financial advisors must accept overly conservative investors who avoid investments delivering losses – or become overly confident investors who pile into positive returns, despite the so-called sunk cost fallacy. During stock market crashes, they also resist selling stocks after their prices plummet.
People susceptible to loss aversion are often unaware of their errors, hanging on to declining stocks, hoping for a rebound, when they need a substantial rally to overcome their large purchase price that cannot be justified. Events in the market can set bad investor triggers when there is a sudden change in market condition due to, for example, news stories, or TV appearances by companies in which the investor is already committed. Investors can mitigate the impact by conducting long-term historical probabilities of specified events.
