In the same way that emotional and cognitive factors can determine an individual’s behaviour, they also can — and do — influence investment behaviour. Investor behaviour reflects the thoughts, emotions, and biases of individuals participating in the market. It encompasses the decisions investors make — from the stocks they choose to how often they trade, what assets they trade, and their rationale for making these decisions.

In fact, the field of behavioural finance is dedicated to studying how human emotions and cognitive biases can and do impact investment behaviour. These biases can lead to irrational investment decisions, which can harm investment performance. Understanding and mastering investor psychology will not only explain how biases impact an investor’s approach, perceptions and behaviours when investing, but also how an investor can avoid the pitfalls and have greater success in meeting your long-term investment goals.

Understanding Investor Psychology Is Crucial

When you invest you take a big risk with your capital because your portfolio’s value, and any income you receive from it, has the potential to decrease or increase in value or record. While the aim is to make money, it is possible that you could get back less than you invested.

Benjamin Graham, the father of value investing, once said, “An investor’s chief problem and even his worst enemy is likely to be himself.” Understanding investor psychology and biases is vital for making informed investment decisions while avoiding certain traps that can negatively impact your investing success.

Here are three traps every investor should seek to avoid:

Herd Mentality

Herd mentality occurs when investors follow the actions and decisions of the majority without conducting independent analysis or due diligence. This behaviour is often driven by the fear of missing out (FOMO) or the belief that others possess better information, leading individuals to invest with the crowd.

In the stock market, this can lead to volatility in the form of market bubbles or speculative frenzies, as well as a lack of diversification. Investors may rush into popular assets or stocks, driving prices to unsustainable levels, and when these asset prices collapse, many investors can suffer significant losses.

One classic example of herd mentality in the United States stock market is the late 1990s and early 2000s dot-com bubble. During this period, the stock prices of many Internet-based companies soared to astronomical levels. As the internet gained popularity, investors were drawn to internet-related stocks, and the market witnessed a massive influx of capital into these companies. The perception was that “everyone else” was making money in these tech stocks, so more investors wanted to join the party and not miss potential gains. Investors followed the crowd, ignoring traditional valuation metrics and invested based on speculative hype. Many of these dot-com companies had little to no revenue, let alone profits, yet their stock prices continued to skyrocket. Investors who had blindly followed the herd suffered substantial losses as the prices of many dot-com companies plummeted, and numerous businesses folded. This underscores the importance of conducting thorough research and making investment decisions that are based on fundamental analysis, rather than following the crowd.

Overconfidence

Alternatively, an overconfident investor may believe he or she possesses superior stock-picking skills or market-timing abilities, leading him to take excessive risks. In doing so, investors fail to consider the broader market context or company fundamentals. This can lead them to make frequent trades or concentrate their investments on a few high-risk assets, assuming they can consistently outperform the market. However, this belief can be unfounded, as overconfident investors may overlook the risks associated with their decisions, resulting in subpar returns or significant losses. For example, individual investors may exhibit overconfidence when selecting specific stocks based on limited information or without conducting thorough research. Another example is where overconfident investors often attempt to time the market, believing they can accurately predict the best times to buy and sell assets. They may try to sell before a perceived market downturn or buy at the bottom of a dip. However, it is exceedingly difficult to successfully time the market consistently, and overconfident investors may miss gains or incur losses, due to mistimed trades.

To mitigate this bias, investors should recognise their own limitations and acknowledge the inherent uncertainty in financial markets. Additionally, sticking to a well-defined investment strategy and maintaining a long-term perspective can also help investors temper the negative effects of overconfidence.

Loss Aversion

As the name suggests, loss aversion is when an investor goes to great lengths to avoid the potential losses inherent in investing because losses have a greater psychological impact than gains. Simply put, the pain of a loss in an investment is twice as impactful as the pleasure of a gain. This trap manifests in various scenarios, including an investor not buying enough of a stock out of timidity, which could result in the investor experiencing missed opportunities such as missing capital appreciation or not earning all the dividends they could have had they not yielded to fear. Loss aversion in investing can also induce investors to hang onto failing investments for too long, expecting they will recover, while selling winning investments too quickly to lock in profits. This emotional tug of war can seriously impair an investor’s ability to make sound decisions. Of note, investors who are highly loss-averse may avoid investing in riskier asset classes, such as stocks or emerging markets bonds, even though these investments may offer higher potential returns over the long term. They may prefer to allocate their portfolio to safer, but lower-return assets to minimise the risk of experiencing losses. As a result, they might focus solely on “safe” investments, such as bonds or cash, even in periods of low-interest rates or inflation. They may prioritise the preservation of capital overachieving higher returns, potentially hindering their ability to keep pace with inflation and grow their wealth. However, investors can avoid this trap by speaking to a financial advisor and do research before making an investment decision, focus on building a diversified portfolio and adopt a long-term view when investing.