PSYCHOLOGY OF
INVESTING

The “psychology of investing” revolves around the emotions that can influence your decision-making throughout the entire life cycle of a trade. It is essential that traders and investors develop the right mindset and have a strategy in place in order to avoid emotional investing and the risks that come with it.

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Conscious and subconscious aspects of human behaviour can unintentionally influence your decision making and investment returns. Emotional investing is usually bad investing, and these are some of the psychological pitfalls which investors should be wary of.

What Do We Know About the Psychology of Investing?

Studies into the psychology of investing highlight that there are obscure biases which can influence your decision making and which need to be understood. Regardless of the amount of money at stake, it’s important to be aware of how psychology and emotional investing can impact your returns, as well as how you respond to market events. Discover what emotional investing is and how to avoid it.

The most important quality for an investor is temperament, not intellect.

Warren Buffett

Understanding the Psychology of Investing

There are lots of emotions attached to investing, although these emotions will vary depending on the exact stage of the process.

Planning Stage

When developing your investment strategy, extra caution is required to avoid falling into some of the pitfalls experienced by new investors.

Pitfall	Definition
Familiarity Bias	Investors focus on assets and markets they’re familiar with, rather than exploring new areas that might be a better fit for their risk-profile.
Anchoring Bias	Investors rely heavily on the first piece of information they receive, which leads to them overlooking other, relevant factors.
Restraint Bias	Investors overestimate their ability to show restraint in the face of temptation, which could lead to greater exposure.
Herd Mentality	Investors let their investment decisions be influenced by the actions of others, rather than through their own research.

Investing Stage

Once you’ve entered into a position, the way it fluctuates in value according to live market prices can trigger a range of other factors and biases, not necessarily witnessed in the planning stage.

At this stage, investors will possibly start to experience losses, which makes them question their strategy, and whether there has been a shift in market conditions that makes it ineffective.

Pitfall	Definition
Confirmation Bias	When investors seek out information that supports an investment decision, rather than new, alternative views that might challenge it. This can leave investors blindsided when things go wrong, because they’ve convinced themselves that their decisions are financially viable.
Loss Aversion Bias	When investors have a risk profile that prioritises avoiding losses over making gains. A lower risk-return ratio is unlikely to provide the long-term rewards that investors are looking for.
Win-Loss Ratio	When investors want every trade to be successful, and so stick with bad decisions rather than cutting losses.

In addition, investors should consider another crucial bias: the tendency to procrastinate. Regardless of which emotions can come into play, the reasons for investing remain valid. Whether you’re looking to protect your wealth from inflation or planning for financial independence and early retirement, procrastination is a problem that many new investors face. Sometimes, the biggest risk is not taking any risks at all.

What is Emotional Investing?

Emotional investing is when feelings caused by price movements impact your investment decisions. For example, if the market is trending upwards, the positive feelings associated with this may cause an investor to make rash decisions. This could also be true when the market experiences a downturn.

How to Avoid Emotional Investing

More important than anything else, new investors need to acknowledge that, no matter how foolproof their strategy is, there will be losses at some point along their investment journey. 

Experienced investors tend to focus on their long-term goals, rather than short-term pain from any temporary losses, which can help to avoid emotional investing. Don’t focus on your win-loss ratio, but instead, aim to make an overall positive return. Consider the phrase: “run your winners and cut your losses.”

Each of the psychological factors that can lead to emotional investing can be addressed individually, with a well-thought-out, overall plan.

• Conduct as much research as possible and keep up to date with market news.
• Be realistic about your aims and personal risk profile.
• Diversify your portfolio to reduce volatility.
• Review your actions and investment plan to make sure you’re avoiding beginner investment mistakes.
• Consider updating your strategy, or better still, factor in adaptations at the planning stage, depending on how certain scenarios might play out.

Final Thoughts

Regardless of whether your investment portfolio is rising or falling in value, there are methods you can use to develop an investing mindset and optimise your returns. Develop an understanding of the ways in which greed and fear can cloud decision-making and instead concentrate on influencing the elements of the investment process that you do have control over.

Visit the eToro Academy to learn more techniques designed to help you to develop a successful approach to trading.

Quiz

FAQs

Is there a way to measure the mood of the market?

The CBOE Volatility VIX Index measures trading activity in the options market. These instruments are often used to manage risk; the greater the amount traded, the higher the number of investors who believe that the US stock markets could experience a dramatic price move in the near future. Based on data from the Chicago Board Options Exchange, it is used to monitor investor sentiment. Sometimes called “the greed and fear index,” the higher the reading of the VIX, the greater the concern from investors that price volatility will increase in the future.

What techniques can I use to take the emotion out of investing?

The dangers of emotional trading have prompted a range of strategies to be developed to counteract it. Portfolio diversification involves buying a variety of assets which can average out returns and reduce the emotional reaction to increased market volatility. It’s also worth considering dollar-cost averaging, where investors place equal amounts of capital into their investment plan at regular, predetermined times or price levels, thus, removing an element of emotion.

How much should I invest to avoid emotional investing?

Traditional investment advice suggests that investors should avoid committing more capital than they can afford to lose completely. For beginner investors, starting off small and gradually building up your portfolio, will help you to acclimatise to the inevitable ups and downs of the market.