The Influence of Psychology on Investment Decisions: How to Avoid Biases?

How Does Psychology Affect Investment Decisions?

In the world of investments, where data and analysis seemingly reign supreme, it’s easy to forget the immense power of human psychology. The capital market, despite being based on numbers and graphs, is ultimately driven by people – with emotions, fears, and hopes. Understanding the psychological impact on investment decision-making is critical for success in this competitive market.

Many investment decisions are made under pressure, whether it’s market volatility or the fear of missing an opportunity. In such situations, emotion often trumps logic, and investors may make impulsive decisions that are not based on thorough analysis. Human psychology influences how we perceive risks, react to losses, and cope with uncertainty.

Many investors have experienced this impact firsthand, finding themselves acting against their original strategy, driven by fear or greed. A deep understanding of common psychological biases can help investors identify these pitfalls and act more rationally.

Why Does Everyone Do the Same Thing? Herd Mentality in Investments

One of the most common psychological biases in the world of investments is herd mentality. This phenomenon occurs when investors tend to act on what “everyone is doing,” without examining the data themselves or understanding the economic logic behind a particular movement. In other words, instead of making independent decisions, they join the herd, thinking that the power of the majority will protect them.

Herd mentality can be very dangerous, especially when it leads to the creation of market bubbles. A classic example of this is the dot-com bubble in the late 1990s. Many investors were swept away by the enthusiasm for internet companies, without examining their business models or their ability to generate profits. As a result, the stock prices of these companies rose dramatically, until the bubble burst and left many investors with heavy losses. In such cases, most of the action stemmed from blindly following a sense of opportunity, rather than a genuine analysis of the companies’ value or business forecasts.

The danger of herd mentality is that it can lead to irrational decisions, based on fear or greed rather than a thorough analysis of the market. When investors act out of fear of missing an opportunity (FOMO), they may buy stocks at inflated prices, only to find that they bought them at the peak of the bubble.

The way to avoid herd mentality is by conducting independent and objective research as much as possible, or alternatively, relying on professional investment management that neutralizes the temptation to go with the flow. An independent investor should examine the data themselves, understand the risks and opportunities, and make decisions according to their investment strategy. Relying on professional investment management can help the investor make more rational decisions, as the investment manager acts on a thorough analysis of the market and not on emotions or gut feelings.

When a Loss Feels Worse Than a Profit – Loss Aversion

Another significant psychological bias that affects investment decisions is loss aversion. This phenomenon describes the human tendency to feel the pain of a loss more intensely than the pleasure of an equivalent gain. In other words, a loss of 100 shekels will cause more grief than a profit of 100 shekels will cause joy.

Loss aversion significantly affects how investors make decisions. It can cause them to be too conservative, avoiding risks even when they may yield higher returns, or alternatively, taking too great risks in a desperate attempt to avoid a loss. This feeling causes many investors to hold on to losing positions for too long, hoping that they will recover, instead of accepting the loss and moving on.

One of the common consequences of loss aversion is the “selling effect.” Many investors tend to sell profitable stocks too early, to secure the profit, but avoid selling losing stocks, hoping that they will recover. As a result, they miss the potential to earn more from the profitable stocks, and continue to lose money on the losing stocks. Experienced investors understand that losses are an integral part of the game, and that sometimes a decisive action of selling in time can save larger losses later on.

To cope with loss aversion, it is important to understand this bias and be aware of its impact on decision-making. Setting clear boundaries in advance, such as stop-loss points, may make the decision automatic and neutralize emotion in difficult moments. It is also important to remember that investments are for the long term, and that the ultimate goal is to achieve a positive return over time, even if it involves short-term losses. For more information, you can read about the impact of psychology on investment decisions.

The Feeling That I Know More Than Everyone Else – Overconfidence

Another bias that significantly affects investment decisions is overconfidence. This bias is expressed in an exaggerated feeling of investors regarding their abilities, their knowledge, and the accuracy of their forecasts. In other words, overconfident investors tend to believe that they know more than they really know, and that they are able to beat the market.

Overconfidence can stem from a variety of factors, such as previous successes in investments, in-depth technical knowledge, or an exaggerated sense of control over the situation. When an investor succeeds once or twice, it is easy for them to think that they have “cracked the code” and start taking excessive risks, trading aggressively, or neglecting the need for diversification and balance in the portfolio. This feeling is very flattering, but it can lead to serious mistakes.

One of the consequences of overconfidence is a tendency to take too great risks. Overconfident investors tend to invest too large amounts in individual investments, without spreading the risk properly. They also tend to trade more frequently, believing that they can exploit short-term fluctuations in the market. However, studies show that frequent traders tend to achieve lower returns than long-term investors.

In addition, overconfidence may cause investors to ignore contradictory information or warnings against potential risks. They tend to be trapped in their conception, and unwilling to consider other perspectives. A prudent investor will maintain humility, seek additional perspectives, and use a clear strategy to avoid being swept away by a sense of superiority.

To cope with overconfidence, it is important to be aware of this bias and try to assess our abilities objectively. A stable and pre-defined investment plan, combined with proper emotional management, may reduce the damage caused by this bias. It is also recommended to consult with professionals and hear additional opinions before making important investment decisions.

When the Truth Is Uncomfortable – Confirmation Bias

Confirmation bias is our tendency to seek out and locate information that supports our existing beliefs, while ignoring or downplaying information that contradicts them. This bias greatly affects the way investors make decisions, as it can lead to an unbalanced assessment of risks and opportunities.

Confirmation bias operates on our internal desire to believe that what we think is also correct. Therefore, we seek information that reinforces the opinion we have already formed, and ignore information that contradicts it. This creates thinking bubbles, in which investors are exposed only to voices that support a particular investment and ignore warnings or negative forecasts. For example, an investor who believes that a particular stock will rise will look for positive news about the company and ignore negative news, even if it is more significant.

The danger of confirmation bias is that it can lead to poor investment decisions, based on partial and biased information. Investors who suffer from confirmation bias may overestimate the chances of success and underestimate the potential risks.

Identifying this bias requires high self-awareness and the ability to ask: “Is there something here that I am not seeing?” A deliberate search for contradictory information, and a conversation with professionals or with investors who hold a different opinion, can help broaden the perspective and make a better decision. It is important to examine all angles, even if they do not match our beliefs, in order to get a complete and objective picture of the situation.

When the Irrelevant Past Continues to Influence – Anchoring Bias

Anchoring bias is a cognitive bias in which people rely too heavily on the first piece of information they receive (the “anchor”) when making decisions, even if this information is irrelevant or inaccurate. This bias also affects investment decisions, and often causes investors to make irrational decisions.

Anchoring bias refers to the fact that we tend to stick to a particular reference point – such as a stock’s purchase price or an analyst’s old forecast – even when it is no longer relevant. For example, when an investor sees that a stock they purchased has decreased in value, they may insist on holding it until it returns to its “previous value,” even if all the signs indicate that this will no longer happen. They anchor their decision to the original purchase price, and find it difficult to accept the fact that the stock has permanently decreased in value.

The danger of anchoring bias is that it can prevent investors from making informed decisions based on up-to-date data. They may miss better investment opportunities, or continue to lose money on bad investments.

The way to break free from this psychological anchor is to regularly update valuations and expectations, and to base them on up-to-date data and not on a past that has become irrelevant. It is important to examine our investments regularly, and to re-evaluate them based on the latest information, and not on the original purchase price or old forecasts.

Fear and Greed – Not Exactly Good Investment Advisors

Intense emotions such as fear and greed are an integral part of the human experience, but they can be particularly poor investment advisors. These emotions greatly affect the behavior of investors, especially in extreme moments in the market.

Fear of a collapse or a desire for quick profit can push impulsive actions, which are usually more harmful than beneficial. For example, when the market experiences sharp declines, many investors act out of panic and sell their stocks at a loss, only to find that the market recovered shortly thereafter. On the other hand, when the market experiences sharp rises, many investors act out of greed and buy stocks at inflated prices, only to find that they bought them at the peak of the bubble.

The problem with emotions is that they cause us to make irrational decisions, based on gut feelings and not on a thorough analysis of the market. They also cause us to be less tolerant of risk, and to act too conservatively or too aggressively.

Those who know their personal risk tolerance, and know how they tend to react to pressures, will be able to adjust the investment structure so that it allows them to remain calm even in volatile periods. A solid investment, with broad diversification and personalized risk, may be the right recipe for peace of mind and a reasonable return over time. It is important to remember that investments are for the long term, and that the goal is to achieve a positive return over time, and not to react to every short-term fluctuation in the market.

Headline of News Sites – Not a Basis for Strategy

Recency bias is the tendency to focus too much on current events and give them excessive weight in investment decisions. For example, an investor may sell stocks due to a decline following a war or a negative macro data, without understanding that this is a temporary event that in the long run hardly changes the picture.

The danger of this bias is that it can lead to impulsive decisions based on background noise and not on a thorough analysis of the market. Proper investment requires a broad vision, analysis of trends and not just headlines, and an understanding that the market reacts in the short term but balances out over time. Therefore, it is important not to base an investment strategy on headlines, but on in-depth and long-term research.

Psychological Awareness as an Investment Tool

Ultimately, to become better investors, we first need to become better understanders of ourselves. Recognizing the psychological biases that dictate our behavior, and dealing with them practically, allows us to act more thoughtfully and build an investment strategy that stands the test of time.

Using professional guidance is not only a way to enlist expertise – but also a means to reduce the impact of our personal habits, and to give space to rational, calculated, and as emotion-free analysis as possible. Self-awareness and recognition of psychological biases are an essential tool for any investor who wants to succeed in the capital market.