Psychology in Finance

“The investor’s chief problem – and even his worst enemy – is likely to be himself” ~ Benjamin Graham

Most people don’t stop for a moment and realize that the way we think, behave, or make decisions is linked to multiple fields of study. You can pick two completely different subjects and can tie them together in one manner or another. I find that applying a scope of psychological theories and phenomena allows me to think in a different manner than I would have otherwise. That explains my increasing interest in the fusion of of Psychology and Finance.

Thinking in a psychological manner helps in a lot of ways. It becomes easier to identify the motivations for an individual’s behavior. Reading people and developing this sense of intuition (a la Donna Paulsen) can create this form of assurance of how you are directly impacting others and how you should react in different situations. At its basic core, psychology provides x-ray vision into a person’s mind.

The markets are no different. When it comes down to it, markets have the same mood swings that people do, simply because it’s a reflection of those same people’s moods (which explains how crowd psychology affects both traders and angry mobs). Some people buy at the peak of the market because of FOMO and not understanding how the game is played, when they should in fact be selling. Of course those same people end up selling when the market hits a low when they should be buying. It’s why the smart investors make money off the not-so-smart investors.

There’s a field called Behavioral Finance that takes all of this into account. Behavioral Finance explains why stock markets behave the way they do, why people make certain choices that will make them boom or bust, and even why the term “rational investor” shouldn’t be allowed in finance textbooks. There is no such thing as a rational investor. Much like the Scientific Method, anything that applies to a rational investor is true until you actually experiment out in the real world. Then everything you thought you learned goes out the window.

To understand how the stock market and other financial entities work, it helps to grasp the main biases that play a role in Behavioral Finance (which also affects a multitude of other fields as well):

• Self-Attribution
  • When the market is good and you make money, you typically credit yourself for the gains
  • When the market is going horribly, you blame others or chalk it up to bad luck
• Disposition Bias
  • When investors tend to sell off their winners (regardless of how much they earn) and hold on tightly to their losers (in hopes of it going back to the initial buying price or beyond)
• Confirmation Bias
  • When investors look for information that can provide support in an investment, rather than rationally making a decision based on understanding both sides of risk/reward
• Availability Bias
  • When an investor gets lucky on a recent deal, they think it will happen far more often than they should believe
• Loss Aversion
  • When an investor is more upset about their losses than they are thrilled about their gains

Much like other topics of interest, finance functions with a psychological shadow running behind it. The psychological tendencies found in Behavioral Finance can actually make or break most investors. Understanding how these affect everyday people in finance can help an individual go a long way.