Psychology of Investing

“Winners think differently.. it is not how much you know, though knowledge is important. It is not how hard you work, though nothing worthwhile is achieved without hard work. It is not the depth of your experience, though you cannot become a seasoned operator without it. The real difference is the way winners think”.

These are the words of Colin Nicholson from his book Building Wealth in the Stock Market (John Wiley & Sons 2009) and they sum up the importance that psychology plays in your success as an investor.

What is your psychological mindset?

Don’t be too quick to dismiss psychology as a factor in your development as a successful investor. Being aware of how you think, why you react in certain ways and what biases or beliefs you might have that subconsciously affect your decision making will increase your skills as investor. Not controlling the emotions you might experience such as fear, greed, pride, ego or denial, may impact on the way you invest and, more importantly, on the decisions you make concerning your investments.

Most investors initially think that all they have to do is find the ‘right’ strategy, make an investment, follow their plan and everything will be fine. Doing this though is easier said than done. For example, you have made your investments and built your carefully planned portfolio but along comes the first major correction in the share market and you start losing money. How are you going to react and what will you feel? Most new investors (and even some more experienced ones!) will watch as the value of their investments falls and the emotion of not wanting to lose money means that they hold onto a position in the ‘hope’ that one day it will recover.

Studies have shown that people suffer almost twice as much pain losing $1 as they would feel pleasure in gaining $1 (Kahneman and Tversky, 1991) and this is what motivates investors to hold onto losing positions rather than selling to preserve their capital so that they can invest another day. In this situation emotion is hijacking our decision making skills. Even though we know that we should ‘cut our losses early and let our profits run’, we hold onto a position with the view that until we actually sell the position we haven’t actually made the loss – or that is our rationale, even though it isn’t a logical one.

Investing should be a rational process but we often make it an emotional one. If you spend the time to gain a better understanding of how you think, become aware of your flaws and develop discipline to combat negative psychological effects, you should become a more effective and successful investor.

What to do next?

  • Read through some of the common investing mistakes (and how to overcome them).
  • Do some further reading from the suggested reading list at the bottom of the page.
  • Work through a few of the psychology tests and tools listed below to help your understanding.

Common mistakes and how to overcome them

Are you emotionally attached to your investments?

Everyone has a favourite stock but when you become emotionally attached to a particular investment this can cloud your judgement. When you are emotionally attached you may ignore your money management rules or ignore negative information that the market is telling you about a position. You are making decisions with your emotions rather than your head and this can lead to disaster. Instead, become attached to the effectiveness of your investment plan which lets you enter and exit a position with a calm, focused and disciplined approach.

What losses are you prepared to take?

Accept that every investor does not make successful investments all the time and that it is normal and acceptable to take a loss. To help, determine and accept your maximum loss amount as you enter an investment. Make sure this amount is an amount you are comfortable with. If 2% of your portfolio is too high for you as a risk amount on any investment then reduce it to a percentage that you are comfortable with. Understand that to be successful you can’t afford to lose too much. Manage your risk, take your losses when your investment plan says and don’t let the small losses turn into big ones. Take your losses as part and parcel of the business of investing and above all preserve your capital so that you can continue to invest.

Are you searching for a Holy Grail or a Guru?

Beginners often read a book, apply the book's strategies, have a few winning investments but after a couple of losing investment they abandon the strategy as not working and pick up the next book or guru’s ideas. This is called the Beginner’s Cycle and if you are to become a successful investor it is crucial that you are able to recognise it and jump off. Accept that an investment strategy may not always produce winning investments and understand that managing the losses and the wins in an appropriate way is what leads to success.

We have only touched the surface here on investing mistakes. We encourage you to read more on the subject and have provided a recommended reading list below.

Recommended reading list

Mark Douglas, Trading in the Zone - Relevant for both investors and traders, this book is regarded as one of the best books on the psychology of investing.

Colin Nicholson, Psychology of Investing - Reading this book will make you a better investor or trader. The ideas and methods in it will improve your investing and trading decision making. Everything is explained in a clear, simple style.

Van Tharp, Super Trader – This book on beliefs and how to reprogram them is excellent. While this book is written for traders, it has just as much relevance to investors. Van Tharp also has a psychology assessment on his website that is worthwhile.

Brett Steenbarger, Daily Trading Coach - This book comes packed with lessons on how to become your own investing coach. You also may want to explore his blog which contains a huge range of investing related topics.

Other interesting resources (including psychological assessments)

For a better understanding of the field of Behavioural Finance and in particular how Heuristics (the shortcuts humans use without being aware of them) affect our investment decision making, visit the Stock Market Investing website and explore their Psychology section.

Want to learn about your financial mind and make lasting positive changes? Check out the free Personality Tests at MarketPsych. The tests are free and confidential and, although you need to register, it is definitely worth the effort to gain some insight into your psychology.

Mickael Mangot, 50 Psychological Experiments for Investors - Explains the insights from over 50 groundbreaking psychological experiments. You can learn how to avoid many of the psychological mistakes made by most investors.

Belsky & Gilovich, Why Smart People Make Big Money Mistakes - Provides the latest research in the field of behavioural economics and reveals the psychological forces, the patterns of thinking and decision making behind investing mistakes.