The psychology of investing has become an increasingly important field in understanding financial markets and investor behavior. With key insights from books on behavioral finance and investor psychology, we can gain a better grasp of psychological biases, emotional decision-making, and how psychology drives financial choices. Core issues like overconfidence, loss aversion, herding instinct are critical to analyze for improved investing. This article will summarize key books and research on the psychology behind investing decisions.
Overconfidence leads to excessive trading and lower returns
Many studies have shown that overconfident investors trade more excessively, have lower portfolio returns and take on more portfolio risk. Overconfidence causes investors to overestimate their stock-picking abilities, downplay risk and become convinced that their personal analysis is superior. This results in overtrading, increased transaction costs and worse investment performance over long time periods.
Fear and greed are stronger than rational calculations
Greed and fear play an enormous role in investment decisions, often overriding rational analysis. When prices are rising rapidly in a bull market, greed takes over and investors plunge into speculative assets at market peaks, hoping to profit from momentum. However, this means buying high, the opposite of rational investing wisdom. In market crashes, fear takes over as investors panic-sell quality assets at temporarily depressed prices, often realizing huge losses.
Herding behavior leads to investment bubbles
Herding behavior and social pressure often lead investors to crowd into popular assets, creating bubbles as valuations become detached from reality. We saw this dynamic famously with the dot-com bubble. Investors poured money into internet stocks in the late 1990s, bidding up prices of profitless companies simply because others were doing the same. This herd mentality and ‘bandwagon effect’ produces investment manias that eventually burst.
Mental accounting causes illogical decisions
Mental accounting refers to the tendency of people to treat money differently based on arbitrary attributes. For example, viewing house money from real estate profits as fundamentally different from salary earned at a job. This leads investors to take undue risks with money from certain ‘mental accounts’ while being overly conservative with funds from other accounts, even if the asset allocation should be similar.
In summary, behavioral finance books and research demonstrate the enormous role psychology plays in investing decisions. Understanding biases like overconfidence and emotional forces like fear and greed provides great insight for investors aiming to avoid psychological pitfalls.