Motivation and emotion/Book/2021/Emotions and security investing

Emotions and security investing:
How do emotions impact on security investment decisions?

Overview

Throughout their lives, people constantly choose between decisions that improve their comfort today and ones that improve their comfort tomorrow. Education and financial saving are common examples. By gaining self-control we are able to visualise the long term, which is critical to our ability to strive for our goals. As well as self-control, it is also essential to be less prone and acutely aware to psychological bias in order to reduce our susceptibility to it, we must first understand what these biases are and how to deal with them. Financial investing is common tool individuals use to improve their future comfort. By knowing your investment objective, defining your investment criteria, and broadening your investment horizons, you will be in a better position to control your investment processes(Nofsinger, J., 2018). The purpose of this chapter is to provide a thorough insight into the numerous unknown psychological and neurological emotion-based challenges which everyday investors face throughout the course of their investing journey

The idea that personal psychology can impact investment decisions has historically been dismissed by formal education in finance. The assumption that people make rational decisions has been used for four decades to improve the quality of financial data. People are objective in their predictions of the future. A belief in the self-interest of people has provided some powerful tools for investors in psychology and finance. Modern portfolio theory enables investors, for example, to maximise their returns based on risk despite a given level of risk they are prepared to accept. Pricing models (such as the capital asset pricing model, the arbitrage pricing theory, and option pricing) can help value securities and provide insights into expected risks and returns (Nofsinger, J., 2018). Investment texts are full of these useful theories. However, psychologists have known for a long time that these are bad assumptions. Many people behave irrationally and make predictable forecasting errors. Traditionally, risk aversion is assumed in traditional finance. When the expected rewards are adequate, they won't mind taking risks. The level of risk aversion should be consistent as well. People's behaviours, however, violate these assumptions all the time in the real world. By contrast, buying lottery tickets is associated with risk seeking, while buying insurance is associated with risk aversion.

Investing mistakes have a substantial impact on people's wealth, as well as their reasoning errors. If investors let psychological biases control their decisions, even those who understand a significant amount of modern investing can fail as investors. This chapter will teach you how psychological biases affect decision making, how they affect investment decisions, how they reduce your wealth, and how to recognise and avoid them in your own life.

Psychology and Finance

The brain does not function like a computer. To shorten analysis time, information is frequently processed using shortcuts and emotional filtering (Young, P., 2013). Often, the decision you arrive at through this process is not the same as the one you would reach without these filters. These shortcuts and filters can be called psychological biases. The first step toward avoiding these psychological biases is to be aware of them. Among these biases is overestimating the precision and importance of information. It's no secret that investing is difficult. Many times, you must make decisions with inaccurate or insufficient information. Also, it's essential to develop an understanding of what you are presented with though unfortunately, people, even experienced professionals are prone to making predictable forecasting errors[grammar?].[factual?]

However, traditional finance has ignored psychological biases, even affecting the smartest individuals. In conventional finance, people are considered to be rational, and we learn how to maximise our wealth by following the rules. Psychological concepts such as asset pricing theory, portfolio theory, and option pricing theory have come from these ideas. A behavioural finance distinction can be made between the study of how people behave in a financial setting. This is different from the study of how emotions and cognitive biases influence financial decisions, corporations, and financial markets. This chapter examines a subset of these issues - how psychological biases affect investors. When investors understand these biases, they will also gain a deeper appreciation for the tools available in traditional finance. A decision with risk and/or uncertainty will have the brain use facts and probability estimates to quantify the uncertainty. In addition, the mood at the time of the decision and the feelings about the outcome of the decision both serve as inputs. The fact that emotions often influence decision making should come as no surprise. Most people think of this part of the process as a computer process. It is worth noting, however, that the brain's logic or reasoning part, the brain's computer-like portion, also produces systematic errors. Thus, decisions and the effects of those decisions are often biased, regardless of whether emotions play a role in them.[factual?]

Emotion and Investment Decision Making

Emotions are an important part of the decision-making process. This is especially true for decisions that involve a high degree of uncertainty, such as investment decisions. Sometimes, emotion can overcome logic in this process. Too much optimism leads investors to underestimate risk and overestimate expected performance. Optimistic investors tend to seek good-story stocks and be less critical. Pessimistic investors tend to be more analytical. Extended, extreme optimism can cause price bubbles. On the other hand, some sensation-seeking investors look for the gambling-like emotions from excessive trading (Young, P., 2013).

Risk tolerance is determined by emotions, and risk tolerance plays a crucial role in portfolio selection. Investing is a long-term process. In summary, investors go through a variety of emotions as they: ponder their options, decide how much risk to accept, experience the financial roller coaster while watching their decisions play out, decide whether to stick with or alter their initial strategy and determine whether they have achieved their financial goals. Lola Lopes (1987) describes how major emotions influence risk bearing along a timeline (Young, P., 2013). Folklore stated that greed and fear in the financial markets drive the market. However, this is only partially true, while investors are motivated by fear, they are more motivated by hope[factual?]. Hope-based investors will focus on profitable events, while fear-based investors will focus on unfavourable events. Investors have specific goals to which they aspire, in addition to general fears and hopes. What kind of goals do investors have? A typical retirement goal is to have enough money to support one's children's education and to purchase a home. Both fear and hope are opposites, one positive and the other negative.

This new and fascinating field aims to understand how factors such as the aging process, genetics, hormones, physiology, and cognitive decline affect investing preferences. Additionally, neuroscience shows how the brain makes investment decisions. The age-old question of whether behaviour is nurtured or genetic has become somewhat controversial in recent years[vague].

Investment Decision Making

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Anchoring

Anchoring refers to an over-reliance on what one originally thinks. Imagine betting on a boxing match and choosing the fighter purely by who has thrown the most punches in their last five fights. You may come out all right by picking the statistically more-active fighter, but the fighter with the least punches may have won five bouts by first-round knockouts. Clearly, any metric can become meaningless when it is taken out of context (Lefvere, A., 2017).

For instance, if you think of a certain company as successful, you may be too confident that its stocks are a good bet. This preconception may be totally incorrect in the prevailing situation or at some point in the future.

People tend to be anchored in the first information they hear, regardless of whether it is financial or non-financial, and this can lead to poor managerial decisions when anchoring bias is present. A manager who fails to gather enough information to come up with the most accurate estimates is no different. Even well-informed decisions can be tainted by such biases, leading to poor decisions, and even ignoring good information.[factual?]

There is also a possibility that anchoring in financial markets might cause frustration to investors, as they tend to base their decisions on the wrong number. The prices of some stocks of companies have fallen substantially quickly in the past, and some investors may be interested in investing in stocks of these companies. Accordingly, in this specific situation, the investor sees a drop in price as a valuable opportunity to take advantage of a recent high the stock had achieved and consequently, anchors his purchasing decision on the recent high that the stock has achieved.[factual?]

Certainly, the irrational tendency of the market is able to cause some stocks to drop sharply in value on occasion, but it is also quite common that stocks drop in value because of underlying fundamental changes such as economic conditions, technological advancements or any other number of factors.

Sunk Cost

Sunk cost in investing is psychologically protecting your previous choices or decisions — which is often disastrous for your investments. It is truly hard to take a loss and/or accept that you made the wrong choices or allowed someone else to make them for you. But if your investment is no good, or sinking fast, the sooner you get out of it and into something more promising, the better. (Reyniers, D. 2008)

Sunk costs represent a violation of rational decision making-pursuing [grammar?] an inferior option because we have already invested significant, but nonrecoverable resources in it. The sunk-cost effect has traditionally been viewed as an interpersonal phenomenon (as it is driven by our own past investments); however, current research shows that it is also an interpersonal phenomenon (that is, people will alter their choices in response to their peers' investments)[factual?]. Eight experiments (N = 6,076) covering diverse scenarios showed that there are sunk-cost effects when not the decision maker bears the costs [improve clarity] (Reyniers, D. 2008). The interpersonal sunk-cost effect is not moderated by social proximity or how people see their sunk costs being celebrated[explain?]. These findings uncover a previously unknown bias, and suggest the sunk-cost effect is a global phenomenon that challenges [what?] existing theories.

People commit the sunk-cost fallacy by continuing to invest in a failing plan. Resources that have already been invested cannot be recovered. Therefore, economic theory implies that decision makers should consider losses and gains only in the future.[factual?]

It is well known that sunk costs refer to those costs that have occurred and cannot be recovered in economics as well as in business decision-making. It is important to keep sunk costs out of decisions regarding future budgeting and planning, as they will continue to exist irrespective of future decisions.

When a decision-making process is based on consideration of sunk costs, this fallacy exists. It can be seen that irrational decisions are made when a decision is made taking into consideration sunk costs prior to making a decision.[factual?]

Confirmation Bias

In the investing world, confirmation bias leads people to cling to preconceived notions about their investments, while discounting information that contradicts these ideas. For example, a client whose holdings are concentrated in a specific sector or group of stocks may only absorb good news and ignore bad news regarding these investments. We consistently use confirmation bias to interpret information that influences our decisions in our society, whether it is at home or on global platforms. People are unable to gather information objectively because of this bias.[factual?]

To avoid confirmation bias, question the sources of your information and how your research was conducted.

Searching for information using different information sources could provide different perspectives on a particular topic and provide greater credibility.

Instead of forming conclusions based on headlines and pictures, read entire articles. Find meaningful evidence within the article.
Assess the credibility of the statements that are being asserted (and find out the sources of the evidence).
Establish validity - Become more aware of what information you gather.

Frequently cited [factual?] as one of the most problematic cognitive processes, confirmation bias challenges accurate belief formation and the correction of incorrect views. The phenomenon's problematic nature makes it difficult to explain how the bias developed and continues to exist today. To explain the bias, philosophers and scientists have advanced the theory that it is adaptive. The confirmation bias hypothesis implies the evolution of confirmation bias as a means of influencing people and social structures to align with our beliefs. In doing so, we and others may gain substantial developmental and epistemic benefits, ensuring that, over time, we do not become disconnected from social reality but are better able to navigate it. It is a function that has been overlooked in the research on confirmation bias even though it might not be the only evolved function of confirmation bias.[for example?][factual?]

Herding

A herd instinct is a behaviour wherein people tend to react to the actions of others and follow their lead. This is like the way animals react in groups when they stampede in unison out of the way of danger—perceived or otherwise. Herd instinct or herd behaviour is distinguished by a lack of individual decision-making or introspection, causing those involved to think and behave in a similar fashion to everyone else around them. (Montier, J. 2019)

A single perspective is not sufficient to explain herd behaviour. Observations on herd behaviour can be based on arguments formulated by John R. Commons (1934) in economics and psychology. Despite asking what herd behaviour is, from an economic perspective it focuses primarily on its long-term effects, on how much one can benefit from participating in herd behaviour and from what it has to offer. Based on the choices that herds make, we can evaluate their motivations. Geoffrey Hodgson (1993) argued that this mainstream economics approach has led to far too much of a sense of inevitability regarding individual motivations and preferences, because "the essence of human personality is regarded independently of social relationships with others.".

The history of herd behaviour in economics and psychology clearly shows that the phenomenon has come to be studied from distinct areas of attention. As early as 1934 Commons recognised the structural difference between economics and psychology, in general, that economists focus upon the effects of herd behaviour and more specifically upon the problem of how to benefit from it (Montier, J. 2019). Psychologists, on the other hand, primarily seek to answer why and when people feel motivated to engage in collective behaviour. As a result, herd behaviour in these disciplines is studied from distinct levels of analysis. Economists mostly concentrate upon macro-level processes while keeping individual motivations and preferences constant, whereas psychologists mostly focus upon microlevel processes while ignoring the effects of a given action on the institutional level. So far, exactly those assumptions have yielded weak results[explain?].

True of False?

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Conclusion

Traditional finance concepts are the focus of most formal finance education. Psychological factors also play a significant role in financial decisions. Cognitive errors, heuristics, psychological biases, and emotions are demonstrated in this chapter as influencing factors when making investment decisions. In addition to affecting wealth negatively, psychology-induced decisions also lead to poor financial outcomes.

References

[Use alphabetical order.]

Nofsinger, J., 2018. The Psychology of Investing. 6th ed.

Shefrin, H., n.d. Beyond greed and fear.

Young, P., 2013. Behavioural Investing: Understanding the Psychology of Investing.

Lefvere, A., 2017. Behavioural economics and financial consumer protection.

Reyniers, D. 2008. A behavioural economics perspective.

Reisch, LA. 2017. Behavioural economics, consumer behaviour and consumer policy.

Montier, J. 2019. Behavioural investing.

External links

Mental games of investing: FOMO & letting go of money mistakes (Australian Finance Podcast)
How to invest(Moneysmart.gov.au)
Investopedia