By taking a close look at investor psychology, we can analyze how emotions and cognitive biases influence financial decisions. Unlike theory, which assumes that investors act in a highly rational manner, behavioral finance recognizes that investment decisions are very often influenced by psychological factors, one of the most common examples being the Fear & Greed index.
Cognitive and behavioral biases of the investor
Cognitive biases are errors in thinking that affect investment decisions. To name but a few:
- Confirmation bias: many investors tend to seek out information in a way that confirms their pre-existing beliefs. For example, an investor convinced that a stock will rise will often look for information that supports this conviction, while ignoring information that contradicts it.
- Overconfidence bias: many investors often overestimate their knowledge and ability to predict market movements. This can lead them to take unmeasured risks. According to one study, around 70% of investors consider themselves above average in terms of investment skills.
- Representativeness bias: this bias leads investors to generalize a trend based on a small sample of information. For example, they may assume that a company that has recently performed well will continue to do well, regardless of long-term fluctuations.
The role of emotions in decision-making
Emotions play a very important role in investment decision-making. The two most influential emotions are fear and greed, often measured with the “Fear & Greed” index.
Fear: During threatening market fluctuations, fear can drive investors to sell their assets at a loss, even if the fundamentals remain solid. A striking example is the massive sell-off in equities during the 2008 financial crisis, when markets dropped by over 40% in just a few months.
Greed: Conversely, greed can lead to irrational behavior, such as buying assets en masse in the hope of quick gains. Financial bubbles such as the technology bubble of 2000 are the perfect example of this phenomenon.
The Sheep effect
Another behavior observed among investors is the sheep effect. This consists of following the actions of the majority without carrying out a personal analysis. This effect can lead to extreme market movements and speculative spikes. One of the markets that has experienced this phenomenon the most is the cryptocurrency market during the very frequent period known as the “Bull Run”, when most investors rush to buy cryptocurrencies.
What can you do to avoid investment pitfalls?
To improve their investment decisions, investors need to consider a variety of strategies, and even combine them to optimize results.
One of the most effective ways to develop as an investor is through financial education. Understanding the basics of economics and finance is essential to making more informed decisions. Understanding the basics of economics and finance is essential to making more informed decisions.
Diversification is also often recommended in investment to spread risk and minimize the consequences of emotion-based decisions. It should also be stressed that a long-term approach is needed to avoid reacting to current fluctuations in the financial markets.
Investor psychology is an important field for understanding why and how investors, whether beginners or experts, make financial decisions. By recognizing cognitive and emotional biases, investors can optimize their investment strategies and potentially achieve better returns. Current research in this field continues to reveal interesting insights into human behavior towards investment portfolio management.
