Understanding Investor Psychology

Feb 26, 2018 | Frank Sakellariou


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Throughout history, investors have been unconsciously involving their human emotions in the investment decision-making process, a strategy that has often resulted in the severe loss of capital. Human beings have the capacity to be logical but are more often than not blinded by emotions. These emotions push us to implement fundamentally flawed investment decisions and are currently driving investors into highly speculative products.
 
NeuroScience and Behavior Finance research shows that…
 
“There is an emotional you and an intellectual you” - Ray Dalio
In a recent TED talk, Ray Dalio, founder of Bridgewater Associates, the largest hedge fund in the world, explains how this behavior is related to how our brains are prewired. Essentially, there is a continuous tug of war between our rational selves, driven by a part of our brain called the prefrontal cortex, and our emotional selves, driven by the amygdala.
 
“When people are free to do as they please, they usually imitate each other” - Eric Hoffer
This can also be explained by a human tendency called the Conformity Bias. This tendency prevents us from exercising our own independent judgment and instead, imitate each other. A recent RBC Wealth Management article argues that “No matter how rational or detached we’d like to think we are, the reality is that emotions often get the better of us”. It explains how this “herding mentality” enables us to get carried away with “the next big thing”. Click here to access this article.
 
“We are not thinking machines that feel, we are feeling machines that think” - Antonio Damasio
The study of human behavior can be very applicable to the world of finance. The merits of this scientific study have been recognized by academics and investors alike, so much so that the 2017 Nobel Prize in Economics was awarded to economist Richard Thaler for his contributions to behavioral economics.
 
In a fast-moving world where the “next big thing” always appears to be around the corner, it is important to at times take a step back and have the courage to swim against the current. Eliminating all human emotion can be difficult, but understanding our own human bias can give us insights into why people act the way they do and why markets move the way they do.