Last Updated on 14/05/2023 by Carl-Peter Lehmann
Investing is hard. A lot of that has to do with investing psychology. Not simply because the process and factors that govern successful investing can seem complicated (especially if you don’t work in the field) – risks to consider, selecting the right fund/portfolio, optimal asset allocation, how to effectively diversify, time horizon … but also because investing is an extension of how we think and feel about money. The psychology of investing and how our behaviours – underpinned by fear on the one side and greed on the other – can lead to poor outcomes. Understanding creates awareness and ultimately leads to better decision making.
Psychology of Investing
Money elicits very strong emotions in all of us. It forms the fabric on which modern society is built. It provides for essentials. Food, clothing, shelter. Economic prosperity is measured by it in terms of how much money flows through an economy in exchange for products and services.
Our relationship to money is also complex, a lot of which would have been formed by our upbringing. Was money (or our perception of it) as children at home plentiful or scarce? What were we taught about the value of money? Did money provide us with opportunity, or did a lack of money provide us with a lack of opportunity … in the form of education, access etc.?
Importantly, money also represents status and power … and our economic and social structures celebrate those that acquire it or have it, which means consciously or subconsciously we are always measuring ourselves against some imaginary benchmark (typically peers and friends) in terms of how much money we make and the assets we own (houses, cars etc.)
Why is this important?
Because our relationship to money shapes our behaviours in terms of how we spend money, the value we place on acquiring it, and the decisions we make when it comes to giving, sharing, investing etc.
Those behaviours will then inform whether we make choices that empower us and allow us to achieve outcomes that are important to us, e.g., taking care of loved ones, achieving financial security, leaving a legacy – or whether we make choices that are self-destructive – like living beyond our means, accumulating debt, or even things like gambling that we hope will allow us to improve our station in life, but inevitably lead us even further down the rabbit hole …
Awareness and understanding of our blind spots and the choices we make with regards to money, allow us to change our behaviour and make better financial decisions.
Investment Behaviours and Biases
Making an investment decision is an extension of our views and relationship to money. The risks we’re prepared to take, the kind of assets and products we are more likely to invest in, our behaviours around losses and gains. The field of behavioural finance is a relatively new area of research that only came to prominence in the 1990s and aims to understand the psychological triggers and behaviours that govern our decision making with regards to money and investing. The biases we have and therefore mistakes we all make as investors are insightful and interesting to understand. We feel the risk of a loss twice as strongly as we do a gain. That means we often make poor decisions with regards to our investments as the graphic below illustrates.
Looking at that chart its easy to identify where you sit on that scale after the year we had in 2022. Somewhere between denial and anger is probably not far off for many people?
When you open your brokerage account, look at your portfolio value, or retirement fund statement – at best it probably feels deeply uncomfortable even if you have a lot of investment experience and been through difficult periods and market cycles before.
Feeling anxious, angry or depressed is normal. But even if you have those feelings, you don’t need to act on them. What we’re going through now is nothing that hasn’t happened before – markets move in cycles and how closely you zoom in or out over recent history will have a big impact on how you feel. That’s why time horizon matters. A 1-year chart might look terrible, but look at it over 10 years and things look a lot better.
It’s also interesting to observe that when things are going great and markets are going up, our natural inclination is to want to invest more. Yet when markets are falling, and those same assets are cheaper (which typically correlates to better value), our instincts often lead us to want to sell.
And that is probably the biggest reason why many ‘ordinary’ folk (as in people who don’t do this for a living) or as industry likes to describe them, ‘retail investors’, achieve poor long-term investment outcomes. Buy high, sell low. The opposite of what we’re supposed to be doing. That’s why the JP Morgan chart below clearly shows how the average investor underperforms over time. Poor decision making informed by our behavioural biases.
Investing Psychology 101
Some of the main behavioural biases that contribute to poor investment returns:
- Herd mentality – investing in something because everyone else is. Crypto mania, speculative technology and meme stocks being recent examples.
- Recency Bias – being more influenced by recent performance or trends like assuming the investments that performed best in recent times will perform best in future. Does FAANG dominate in the next decade like it did the last? Unlikely.
- Confirmation Bias – looking for answers or views that support your own and don’t consider alternative or opposing arguments. Markets always go up, or do they?
- Loss Aversion Bias – staying with a losing investment or refusing to invest out of fear. Staying in cash because that’s ‘safe.’
There are many other behavioural biases that influence our investment decision making and fundamentally inform the psychology of investing. Investing is hard. If it were that easy everyone would be filthy rich, lying on a secluded beach, drinking cocktails. But understanding some of your blind spots and behaviours that can railroad you, will go a long way to helping you achieve your goals and grow your wealth.
What to Read Next: Stocks to Buy Now is a fun piece that explores a three megatrends and some investing ideas in each, including shares and ETFs that are interesting and worth exploring further if stock investing is your thing.
Investment Risk - Friend or Foe?
Not being prepared to take enough risk is another common trap. Being over exposed to cash and other instruments that are most affected by the ravaging impact of inflation is a typical sign – because you’re anchored to the belief that you’ll lose your money if you invest in assets that provide the greatest probability to achieve long-term inflation beating returns.
Understanding why you’re investing, what outcome you’re trying to achieve and creating an investment strategy customised to your needs and ideals, is one of the most effective methods for combatting poor decision making in tough times – and empowers you to be able to deal with the changing tide as it ebbs and flows, whether up or down, through good times and bad.
If your only motive is profit, it becomes a lot tougher. Investing without purpose is like a ship without a rudder. You’re vulnerable to the mood of the ocean. In good times, it’s great. When storm clouds gather, you’re more likely to make mistakes.
Human behaviour and our natural instincts will always oscillate between fear and greed. And our relationship to money (and sub-conscious beliefs) will only amplify that.
As difficult as things seem and feel right now, evaluate what outcomes you are aiming to achieve and whether your investment strategy (s) really aligns with that. A clearly defined purpose and strategy will help you to navigate these treacherous times until calmer waters appear. Thank you
Carl-Peter Lehmann
Carl-Peter is a Director and Partner at Henceforward. Understanding human behaviour and how it relates to investing is something he is fascinated with so we can all become better investors
