Last Updated on 31/10/2024 by Carl-Peter Lehmann
Pscyhology of Investing: Investing is hard, and much of that comes down to the psychology behind it. Successful investing requires navigating a complex landscape – assessing risks, selecting the right funds or portfolios, optimizing asset allocation, diversifying effectively, and considering time horizons. Yet, beyond these technical factors, investing reflects how we think and feel about money. Our emotions – often swinging between fear and greed – can easily drive us toward poor decisions. By understanding some core principles of investment psychology, we can become more aware of these influences and make choices that lead to better long-term outcomes
Psychology of Investing: Understanding Our Complex Relationship with Money
Money elicits strong emotions in all of us. It’s what provides for our essentials – food, clothing, shelter – and drives the economic engine, reflected in the flow of money through an economy for goods and services.
Our relationship with money is often deeply personal, shaped largely by the values and experiences we absorbed as children. For some, money was abundant, while for others, it was scarce. What did we learn about its value? Did money open doors, or did the lack of it limit opportunities in areas like education or access to resources?
Moreover, money represents status and power, and our social structures often celebrate those who have it. This creates a subtle pressure, consciously or subconsciously, to measure ourselves against others—friends, peers, or an invisible standard—by the money we earn or the assets we own, like houses or cars.
Why does all of this matter?
Because our relationship with money influences our behaviors: how we spend, save, invest, and even share. These behaviors ultimately guide whether we make empowering choices – taking care of loved ones, securing financial independence, or leaving a legacy – or choices that set us back, such as living beyond our means, accumulating debt, or gambling in hopes of a quick gain, which often only deepens our struggles.
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 often a reflection of our personal beliefs and attitudes toward money. It influences the risks we’re willing to take, the types of assets and products we gravitate towards, and how we react to losses and gains. Behavioral finance, a field that emerged in the 1990s, seeks to explore these psychological drivers and the behaviors that shape our financial decisions. The biases we carry – and the common mistakes we make as investors – offer interesting insights. For instance, research shows we feel the pain of a loss about twice as strongly as we experience the pleasure of a gain. This often leads to impulsive or overly cautious decisions with our investments, as the graphic below illustrates.
Looking at that chart, it’s likely many of us now sit closer to the “thrill” or even “euphoria” stage, thanks to the strong returns we’ve seen over the past couple of years. The mood has lifted from the low points of previous years, and for many, logging into a brokerage account or checking a retirement fund statement feels a lot more rewarding these days.
This upbeat feeling can be energizing, but even with positive performance, it’s essential to stay level-headed. Market cycles are always in play, and how closely you zoom in or out can shape your perspective dramatically. While a one-year snapshot may look fantastic right now, a longer-term view reminds us of the natural ups and downs, reinforcing the importance of maintaining a long-term mindset.
Interestingly, as markets rise, the instinct to invest more becomes almost irresistible. Yet, when markets turn, our reflex is often to withdraw—even though those downturns typically present better value. This tendency is why many “retail investors,” or everyday investors, find themselves underperforming over the long term. Buying high and selling low is the classic pitfall, and as the JP Morgan chart below shows, behavioral biases often lead the average investor to miss out on optimal returns.
How Average Investors Underperform Their Funds and Benchmarks Through Poor Decision Making
Investing Psychology 101: Recognizing the Behavioral Biases That Can Sabotage Your Investments
Key Behavioral Biases That Undermine Investment Returns:
1. Herd Mentality – This is the urge to invest in something just because everyone else is doing it. Recent examples include crypto mania around many alt coins, speculative tech stocks, marijuana, the metaverse (that might still become a ‘thing’.) Following the crowd can feel reassuring but often leads to risky, hype-driven decisions that may not align with your goals.
2. Recency Bias – Being overly influenced by recent trends or performance, like assuming the best-performing assets of today will keep delivering tomorrow. For example, will the MAG 7 stocks dominate in the next decade as they did in the last? Probably not.
3. Confirmation Bias – Seeking out opinions or data that support your pre-existing views, while ignoring contradictory evidence. Believing that “markets always go up” is one example of confirmation bias that can lead to complacency, leaving investors exposed to market shocks.
4. Loss Aversion Bias – This bias makes us fear losses more than we value gains, leading to behaviors like holding onto poor-performing investments for too long or staying in cash because it feels “safe.” While cash might avoid short-term losses, it can prevent long-term growth.
These are just a few of the many behavioral biases that influence investment decisions and shape the psychology of investing. Investing is tough, and if it were easy, we’d all be sipping cocktails on a beach somewhere! But recognizing your own blind spots and behaviors that can derail your decisions is a powerful step toward achieving your goals and building wealth with confidence.
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.
Navigating Market Waves: How Purposeful Investing Can Keep You on Course
Avoiding risk is another common pitfall. Many people are overly exposed to cash or similar assets that are especially vulnerable to inflation’s erosion over time – often because they’re anchored to the belief that investing in assets with higher growth potential might mean losing their money. Yet, these growth-oriented assets are the ones most likely to deliver inflation-beating returns in the long run.
The most effective way to counter poor decision-making, especially in turbulent times, is by understanding why you’re investing and knowing the outcomes you’re aiming for. Crafting a strategy that reflects your unique needs and values empowers you to ride out the ebbs and flows of the market, through both good times and tough ones.
If profit is your only motive, investing becomes much harder. Without purpose, investing is like sailing without a rudder—you’re at the mercy of the market’s mood. In rising markets, this can feel exhilarating, but when the seas get rough, it’s far too easy to veer off course.
Human behavior naturally swings between fear and greed, and our relationship with money (along with our subconscious beliefs) only magnifies these instincts.
As challenging as things may feel, it’s worth evaluating whether your strategy genuinely aligns with the outcomes you want to achieve. A clear sense of purpose and a solid plan can help you navigate even the most treacherous times until the waters calm once more.
Further Reading: Understanding Investment Risk and Volatility To Become a Better Investor
Carl-Peter Lehmann
Carl-Peter is a Director and Partner at Henceforward with over 20 years experience. Understanding human behaviour and how it relates to investing is something he is fascinated with so that we can all aspire to become better investors by improving our decision making.
