THE PSYCHOLOGY OF INVESTING
The importance of the psychological (or emotional) aspect of investing cannot be underestimated or ignored. Whilst some might be quick to dismiss investor psychology as waffle, it is so paramount to being a successful investor that a new field of scientific research has emerged of late, known as behavioural finance. This field of study examines human cognitive processes such as decision-making and investigates how various emotional and behavioural biases are engaged by humans in the field of investing.
The basis of much human error in the field of investing derives from the human tendency to employ and rely upon what are known as heuristics, or rules of thumb. Heuristics are essentially shortcuts that humans use without even being aware that we are doing so. We apply such rules of thumb as it is instinctive within us to do so. These instincts are hard wired into the brains of humans. In fact, the engagement of heuristics and biases is what is referred to in science as being evolutionarily adaptive.
Now, these heuristics and biases are unknowingly employed to enable us to make the right decisions based on the limited information available to us in many situations. However, such shortcuts can lead us astray under certain circumstances and the field of investing is one such area.
Here is an example of the way in which we employ heuristics. It will help shed light on how it affects our investment decisions. When considering whether to drive or fly from New York to Washington DC, most people would view flying as more of a risk to their safety, particularly in the post-September 11 world. People engage heuristics and biases, shortcuts essentially, to come to this decision. They quickly assess what limited information is available to them and they come to a decision, which in this case is to drive. And yet, driving is more dangerous than flying. In this instance, the automatised engagement of heuristics has led them to the wrong decision.
Many investors say things like “I can’t sell XYZ because I bought the stock at higher levels” and “I like the company so I bought it”. This highlights the emotional impact of investors on their decision-making process. Investing should never be an emotional process, but rather it should be a rational one. But unfortunately, we are emotional animals, so discipline and awareness of our flaws is exceedingly important. Following is a look at the specific heuristics and biases, also known as cognitive illusions (doesn’t this term tell us how misleading our instincts can be), that can lead us astray in the stock market.