The relationship between psychology and stock investing

Our psychological biases come to bear on our investing habits, leading to outcomes we'd rather avoid.

If you thought that investing in the stock market is all about crunching numbers, you will be surprised to learn that your own psychology is as much, if not more important when it comes to making critical decisions. The study of the mind and behavior as it relates to how we invest is a subject that is not only extremely interesting, but also greatly useful to investors. Since market moves tend to be erratic and often irrational, self-awareness can help us recognise when our instincts are not grounded in clear thinking. Nothing is more unfortunate than losing money despite having the right research at one's fingertips, simply because of the very human tendency to act and think in certain ways.

One important area that stock-market psychology explores quite a bit is thinking biases that investors suffer from. A bias is a faulty way of thinking that we have grown accustomed to. Take this instinct called loss aversion for instance. Investors react to losses more intensely than they react to gains. So the joy of making a gain of Rs 10,000 is not as intense as the pain of incurring a loss of Rs 2,000. This is what makes investors sell their stocks in panic if the market goes down. And then as more and more investors join the frenzy, a crash ensues.

Now consider the confirmation and availability biases. While researching a company, investors tend to focus on data and information which are easily available to them. This is an example of the availability bias. Instead of looking for important, though less easily available data, investors base their investment thesis on information they do not even have to seek out. What's more, if they already have an opinion, they fixate on information that confirms their viewpoint, rejecting any conflicting data. These two biases result in incomplete research, which often comes back to haunt them later.

Then you also see herd behaviour play out in a very big way in the stock market, so that particular sectors or stocks become overpriced. The latest market fad is IPOs. In today's booming market, many IPOs have given good listing gains. This has attracted a growing group of people who call themselves 'IPO investors.' Seeing this euphoria, more and more companies are making a beeline to the list. The problem is that herd behaviour often leads to 'market stampedes' which leave investors bruised and wounded.

The iconic investor and Warren Buffett's partner Charlie Munger has talked about the liking/loving tendency, where investors frequently fall in love with their stocks. The fact that they have researched them, held onto them for a long time and perhaps are even making paper profits on them, stops them from being objective about them. They tend to ignore any adverse business development. This eventually results in wealth destruction. Even at this point, the 'loving' tendency causes investors to stay invested in hope of a recovery.

These biases are just a few among the many more that exist, many of which are amply explored in books available on the subject. Some of the good ones are Misbehaving by Richard Thaler, Thinking, Fast and Slow by Daniel Kahneman, and The Art of Thinking Clearly by Rolf Dobelli. A classic is Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay. One of the more recent books on the subject is Dollars and Sense by Dan Ariely and Jeff Kreisler. By throwing light on investor psychology, these books promise to help investors become more rational about stock investing.