It has been observed that investor reactions based on their psychological beliefsexercise a heavy influence on the market. Whenever you invest in the stock market, you aim to buy low and sell high. However, our psychological biases can disrupt this clichéthereby making it difficult for us to make smart investment decisions.
Psychological FactorsAffecting Stock Market Behavior
Many investors indulge in the trading activity of the stock market. Their characteristics, thoughts, and psychological beliefs arethe major factors determining the way share prices progress. For that reason, it is important to develop a deeper understanding of human psychology when assessing share market investment opportunities. That is because human psychology can exert a greater influenceon the opportunities that investors can benefit from.
Biases – Psychological traps can create biases among investors when taking investment decisions. When biased, investors rest their expectations upon previous experiences by enforcing stereotypes.In such cases, investors think that if this happens then the other thing will happen. As the predictions in this case are simply based on stereotypes, it can produce bad investment results.
For instance, a self-controlled and wealthy investor may completely avoid high dividend paying stocksbecause of the tax penalties and their effect on portfolio return. Such a behavior in stock market investmentcan create bias in the long run.
Overconfidence–Overconfidence can also lead to over trading, unexpected losses, and less portfolio diversification. When investors are overtly confident in their predictions, it can lead to surprises later since they underestimate the value ofpotential returns.
Loss Aversion – Loss aversion is when the investor is unwilling to acknowledge losses. This happens when the investor is still holding on to a stock that may be significantly lower from its purchase price – on tenterhooks that they will recover.Such investors are like gamblers who continue to roll the dice, hopeful that it breaks even.
Regret – Regret is when the investor associates himself with a bad decision. In such cases, the investor starts thinking “if only I had…”For Instance – after selling off the stockand then watching itrise further, the investor starts wondering if he had held on a little longer, he could have earned more. This behavior can lead to greed.
Greed–Greed often causes stocks to rise further than what they deserve. This means that they tend to rise higher than the justified value of future earnings potential. Having up-to-the-minute information can createa rage in the market creating a fear of being left behind. Such a situation does not allow investors to rationallyevaluate and buy the stock.
[Source : CNN Fear and Greed Index]
Fear –Fear driven by negative information can cause investors to rush for stocks. During market crashes, majority of the selling that happensis out of fearand not based on rational thoughts. It tends to present mistaken valuations in the market that can make it tricky for smart investors to capitalize.Such emotions prevailing amongst investors in the market can amplify new information which can pull the stocks back where it was or push it further based on the information.
To conclude, it is extremely important for the investors to base their trading decisions on rational grounds meaning variance analysis and risk return profile and not on rules, stereotypes, and biases, because it can lead to losses in the long run.
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