14 February 2023

Psychology of Investing: What you need to know about your emotions when trading


Investing comes together with emotions such as happiness, fear, thrill, regret, and surprise. The study of behavioural finance assists us in understanding the physiological factors which may influence our investment decisions, which could in some instances enable us to master our instinctive, impulsive, emotions to make more rational, knowledge-based, and informed decisions when investing. This article will delve into some of the key concepts of behavioural finance, go over the potential impact this may have on financial markets and assess how investors can use this knowledge to ensure they always make investment decisions based on the facts in front of them.

To achieve this, the article will focus on these three themes:

  • Cognitive biases and the systemic errors traders make

  • Controlling emotions such as fear and greed

  • Mental Accounting and the importance of context

Cognitive biases and the systemic errors traders make

Cognitive biases can be defined as systematic errors in the way investors unconsciously think and are driven to make decisions, rational or irrational ones. Such biases are fundamentally embedded in our very own human nature and can be challenging to overcome. Examples of common cognitive biases that influence our trading decisions include:

  • Confirmation bias: This bias builds on the tendency of some investors to seek out information that only confirms their pre-existing thoughts and beliefs, allowing them to ignore information that may contradict their line of thought. This, therefore, can lead to bad investment decisions in that they are solely based on limited information.

  • Herding bias: Just like sheep being herded all together, this human bias refers to the tendency of traders to follow the crowd and make investment decisions that are solely based on what their peers are doing, instead of first doing their own research and analysis. This can be a particularly bad bias during market volatility or market bubbles, when traders may be investing in assets that are only overvalued due to the demand of the rest of the herd.

  • Overconfidence bias: This human-centric bias results in the tendency of traders to overestimate their ability to forecast future movements in the price of assets in financial markets. Overconfident investors may make impulsive or poorly informed decisions with this bias.

  • Need to be right bias: This bias follows the trader’s need to be right at all costs and pushes him to continue investing in a particular product even when this is a losing venture. This particular bias can be especially dangerous as the trader fails to recognize other paths.

Controlling emotions such as fear and greed

Similar to unconscious cognitive biases, emotions play a vital role in investment decisions and can lead to irrational decision-making. We are all familiar with two dangerous emotions, fear and greed. When a market is doing particularly well, traders become overly optimistic about market conditions and take on too much risk. Likewise, when a financial market performs poorly, traders may become too pessimistic and sell their assets at a loss.

Another common emotion we have all experienced is the fear of missing out (FOMO), which is also a common emotion that has the potential to drive traders to make irrational and impulsive investments. This primarily occurs in situations when investors see their peers making significant returns in a market that is surging, providing them with peer-pressure to join in, regardless of whether it means investing in assets that are highly overvalued or involve a higher risk that the trader is traditionally comfortable with.

Mental Accounting and the importance of context

Mental Accounting refers more to how traders conceptualise money and perceive it as a fungible token. While most currencies are fiat in nature, meaning their value is based on how much individuals and society value them and not on a tangible asset such as gold or silver, mental accounting is the study of how traders make investment decisions based on the intrinsic value they place on money. This can have implications on their risk-to-reward strategies.

For example, money that is gained as a result of hard work can have more value to a trader compared to the equal amount of money they may have inherited or have been gifted. Due to subliminal mental accounting traders may be more willing to have a higher risk on their investments with money they value less. These types of thoughts can also lead to poor decision-making in terms of asset allocation.

Key Takeaways

Being able to understand the psychology behind why traders invest the way they do is crucial to the academic field of behavioural finance. Through self-reflection and acknowledgement, traders can work to manage the impact of their own cognitive biases, emotions, and mental accounting. This will allow them to make much more rational and informed-based decisions. Striving to avoid biases and human-centric emotions is easier said than done, however, by acknowledging the role these play in their investment strategies, they are already in a stronger position.

Disclaimer: Any information presented is for general education and informational purposes hence, not intended to be and does not constitute investment or trading advice or recommendation. No opinion given in the material constitutes a recommendation by M4Markets that any particular investment, security, transaction or investment strategy is suitable for any specific person.

It does not take into account your personal circumstances or objectives. Any information relating to past performance of an investment does not necessarily guarantee future performance.

Trinota Markets (Global) Limited does not give warranty as to the accuracy and completeness of this information.

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