Investor psychology is mainly emotions related to investing money, but also cognitive errors that influence decision making. Investor psychology becomes market psychology because investor emotions are one of the factors that cause market upswings, investment patterns, euphoria and panic-induced crashes. Financial markets are driven by changes in the economic situation, the actions of central banks, as well as emotions and, above all, the desire for profit, or greed and fear. This means that when people invest in the market, understanding the rules of psychology and managing emotions is an advantage.
According to the theory of behavioral rationality, investors can correctly assess the risk and potential return of an investment. In practice, most investors cannot estimate the probability of profit or loss. Most investors make decisions under the influence of emotions, often under the influence of impulses caused by information appearing in the media. In addition, cognitive errors such as confirmation bias affect the decision-making process.
From pessimism to euphoria
Let’s start with the fact that two emotional forces meet in the market, which often make the market go from pessimism to euphoria. Those forces are greed and fear. The desire for profit is what drives investors to risk their money. If we could get ten percent of the profit without taking any risk, why would we invest in funds that could lose value? Interestingly, the desire for profit usually attracts individual investors when a bull market continues for some time and assets are expensive. Investors, blinded by the prospect of profit, ignore the warning signs. When they enter the market when the upward trend is well developed and there is optimism, they often face fear when the market falls. One of the principles of market psychology is that market tops occur when most people are optimistic about the market. Why is this, although most investors know this rule? Why are they joining the investment crowd?
In 1895, Gustave Le Bon published the book „Human Psychology”. In this book, he analyzes crowd behavior, arguing that an individual loses part of his personality and even consciousness when he becomes part of a crowd. Then what he called the collective mind, driven by primal instincts, emerges from the crowd. And while he described the behavior of the masses in the context of revolutionary upheavals, the rules of mass behavior are perfectly suited to describe the behavior of investors in financial markets. According to Le Bon, the crowd needs a leader, does not analyze the situation and reacts under the influence of emotional impulses. An excellent description of the herd behavior of investors in the market under the premise that the market leader is price, not a charismatic leader. Investors’ minds change due to price movement and the paradox is that most investors become more optimistic when prices rise and more pessimistic when prices fall. How did this happen?
Stock market falls are faster and more sudden than rises
In the case of losses, the psyche of the investor is tested differently than in the case of successful investments. In terms of emotional intensity, the pain of losing is two and a half or even three times greater than the satisfaction of winning. This means that market panic can happen faster than market euphoria. This also explains why falls in the stock market are faster and more sudden than rises. Most stock market investors make money during bull markets, so bear markets trigger defense mechanisms that make a significant portion of investors ready to exit the market in case of a sharp decline, regardless of the level of loss. At the current moment in the market, they are not given any rational basis, because all that remains is the desire to „escape”.
Hope and Ego
The question is why investors wait so long for a loss to occur when they see that the market has reversed the trend and their investment is starting to pay off. There are two very powerful forces at work here. One of them is hope. The investor trusts in the improvement of the financial situation and hope makes him wait. Another force is the ego, namely the reluctance to admit that one is wrong. Closing a losing position comes with the uncomfortable feeling that we are not as smart as we would like to be. The investor waits and nurtures the hope that the profit will return to the market.
It usually waits too long. Another mechanism works in profitable trades. Investors often realize profits too soon. The temptation for quick gratification is stronger than the principle of letting profitable investments grow as long as possible. Thus, investors exit profitable investments after earning a few to ten percent and close unsuccessful investments when the loss exceeds twenty to thirty percent.
Need for Confirmation
To make investing even more difficult, it is full of psychological pitfalls that make rational decisions difficult. What happens to an investor who started an investment during a euphoric market phase and begins to lose his investment because the market reversed trend and began to decline? At first there is a small disappointment, but the investor quickly finds the assurance of the experts that it is only a correction. A mechanism works here that strongly affects the perception of information, i.e. the need for verification. An investor is only looking for information that confirms his belief that he is right. And he’s usually right. After the correction, the yield rises and the investor is again in a good mood. Sometimes, however, there is a bear market, and then such a strategy leads to a situation where the stress level makes it impossible to make rational decisions.
Actively or passively
How to avoid it? First, everyone must decide whether they will approach investing actively or passively. If passively and, for example, using a fixed amount investment strategy, he should not pay attention to what happens in the market, but simply buy more fund shares on a certain day (according to the established strategy). If he invests actively, he must define the amount he allocates for risky investments. And it shouldn’t be all available capital. Of course, the goal of investing is to earn a profit, but ask yourself how I will feel when my risky investment starts to suffer losses and at what level those losses do not trigger my defense mechanisms.
Czym jest psychologia inwestowania?
Psychologia inwestowania teaches us that humans are imperfect information processors, prone to biases, errors and distortions of perception. Is it to be expected then that our investment decisions are also open to biases, mistakes and perceptions? Behavioral finance theory argues that it is, and the main lesson is that psychology really permeates the entire financial landscape.
Why should you answer these questions?
If we want to achieve attractive rates of return, we must consider investing in stocks, long-term government bonds or corporate bonds, but with higher risk bonds. By investing in money market funds, we achieve returns comparable to bank deposits, which recently have not even compensated for inflation.
The advantage here is the liquidity of the investment,
but it does not really give us the opportunity to earn ten percent per year (unless inflation is 15). One of the reasons why more and more wealth in the United States belongs to a narrow group of rich people is that they make their fortune in the stock market, and the real income of the working part of society has not been earned. grew in 20 years. If we want to multiply our wealth through investments, we have to take risks. The ability to manage emotions related to investing is one of the most important components of success. The reward is earnings that we certainly cannot get with a bank deposit.
Another interesting book for stock traders
– speculators is „Reminiscences of a stock market player”. The book tells the story of Jesse Livemore, a legendary early 20th century profiteer who started out as a 1
-year-old runaway from home. Then he won and lost millions of dollars several times. He recommended playing with the trend and cutting losses. As you read, it turns out that technology has moved on, the popularity of stock markets has exploded, and psychological problems have remained the same. Greed and fear rule the market.
You can invest in many ways depending
on your personality, character, amount of free time, skills, inclinations and the trading system we use. The most popular game is the stock market, that is the sale and purchase of shares every few days, according to company announcements and macroeconomic environment.
Another option is to predict the long-term prospects of stock companies,
wait until the stocks we have chosen are essentially cheap, buy, then a few years of inactivity and finally – profit. Players who have a lot of free time and prefer technical analysis will probably choose so-called day trading, ie. buying and selling multiple stocks in the same trading session. In relation to risk and future returns, the decision whether to invest in just one company, believing that it will bring us huge profits, or to diversify (diversify) the portfolio by buying several companies, is also important. The risk is then much lower, because the loss of one company can be more than covered by the profit of other parts of our portfolio.
The psychology of the stock investor
is an important factor in the investment process. Especially for short-term players, the constant battle between greed and fear, if not guided by rational decisions, can lead to investment mistakes. The two books of the same name by Pring and Nofsinger: „The Psychology of Investing” can help to understand the problems of our psyche.
I have long been waiting for an investment psychology book aimed at long-term investors. Now I can wholeheartedly recommend The Most Important Thing by Howard Marx. If anything can support the psychological aspects of investing according to Warren Buffett or Benjamin Graham, it is definitely this book.
Today it is profitable to invest via the Internet
Transaction fees are small, you don’t have to gamble your money in the bank, you don’t waste time. There is a wide range of online brokers – it’s best to have an account with the ability to place orders by phone, as glitches do happen. How to choose a brokerage house? – You can use the rank of brokers when you compare some services. Investing through the Internet usually gives you the opportunity to buy companies on the main market as well as the opportunity to invest cash surpluses in mutual funds, bonds or overnight.
Be smart, be ready to invest. It is a good idea to read some books on investment and stock trading strategies to make informed profits in the market. Knowledge does not guarantee success in the stock market, but investing without knowledge is like roulette. To make money in the stock market, we have to accept the fact that not all our trades are profitable – sometimes we close our positions at a loss. Our goal is not to be right. Our goal is to make money.
How important is the psychology of investing?
Using investment strategies can significantly help you trade better, but it is only one of the elements necessary to be complete in the forex market. Famous psychologist and stock investor Alexander Elder wrote the following words in his book „The Profession – Stock Investor”: „Every successful investor must know that the three basic elements of the stock market game are: a sound mental structure, a logical investment system. and good money- management plan”
The first of these elements is in this post topic
Below we describe which emotions appear most often when investing and how to deal with them. A description appears that you can certainly adapt for yourself, which only proves how universal emotions and all investment psychology are, especially in the Forex market.
The second element, the investment system,
you have to create yourself based on what kind of investor you are and how much time you intend to spend investing every day. The last point is the capital management plan. This is described in a separate section, so we recommend that you read the information in it. But back to the topic…