Traditional economists often assert the stock market to be “efficient,” meaning prices accurately reflect value. Theoretically, this makes sense because most people will not buy something if the price is higher than they think it is worth. Underlying this view is the assumption that all information relevant to stock prices is available to potential buyers and sellers. According to this theory, such information is incorporated into the price, and therefore, stocks trade at their fair market value. However, buyers and sellers—like all people—do not always act rationally. On the contrary, we are prone to flawed thinking.
Behavioral finance is the study of psychological influences on investors and financial markets. It focuses on explaining why people sometimes act against their own best interests and make seemingly irrational decisions. Psychologists Daniel Kahneman and Amos Tversky explained how cognitive biases and heuristics (i.e., mental shortcuts) could influence how people make financial decisions.
Cognitive biases are processes that we use to simplify information by processing it through a filter of personal experiences and preferences. They play a significant role in the psychology of investing, and these biases can lead people to make irrational investment decisions. Some biases include:
- Confirmation bias: People tend to seek information confirming their beliefs while ignoring information contradicting those beliefs. For example, someone who believes in a company’s future may ignore unfavorable news about that company.
- Self-attribution bias: People tend to believe that positive outcomes are the result of their skill, but undesirable results are due to external factors, such as bad luck. For example, after prospering in a bull market, some people mistakenly believe they are skilled at picking stocks, leading them to make poor investment choices.
- Anchoring bias: People are apt to value the information received first over what is subsequently learned. For example, a person might hold an investment that has lost value because they previously anchored the value to what they originally paid for the stock.
Heuristics are another type of mental shortcut that are essentially “rules of thumb.” It allows people to quickly reach conclusions or solutions. Although heuristics can be helpful tools, they can also lead to incorrect decisions. One example is the “herd mentality” heuristic. When people see others investing in certain stocks or funds, they may be more likely to do so themselves, even if the underlying investment is not sound. This helps to explain why people are more likely to buy in bull markets and sell in bear markets—the very opposite of buying low and selling high.
Another important aspect of the psychology of investing is understanding the role of emotions in decision-making. For example, people may be more likely to make impulsive investment decisions when they are worried or overly optimistic about the market. This can explain why people might rush to sell their investments during a market downturn.
Overall, the psychology of investing is an important area of study for anyone looking to make informed investment decisions. By understanding the various psychological factors influencing investment decisions, investors can better manage their emotions, avoid cognitive biases, and make more rational investment decisions.
Dr. Kenneth Freundlich, the Morris Psychological Group’s Managing Partner, heads the Neuropsychology and Consulting Divisions. With over 35 years of experience, Dr. Freundlich’s practice is exclusively devoted to neuropsychological evaluation and management consultation.