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The psychology of investment – or how not to lose your shirt

The thinking behind investing
Friday, November 21, 2014

Despite the increasing reliance on computers and algorithms, investment remains a very human world and is driven by sentiment, as much as economics. Indeed, some investors have unswerving confidence in their ability to spot the next “sure thing”, or to predict market direction – self-congratulating when right, and going into utter denial if the investment plummets.

Of course, “professional” investors will comment, loftily, that true investment is not gambling, but the product of thorough analysis and controlled process. However, the reality is that, unless our process is absolutely clinical and based on objective analysis, we are exposed to the psychological flaw of being human. Therefore, our very nature will impact on our decisions and how we implement them.

Psychologists talk about illusory superiority; our ability to overestimate our skills and abilities, relative to others. Investors are no less prone to self-delusion when it comes to making investment decisions; and what can be done to guard against such irrationality?

Over the last few years, we have seen some very volatile stock market conditions. With the benefit of hindsight, we can all point to each occasion when we should have bought … and when we should have sold our holdings. If only it was that easy! The good news is that the markets are cyclical and, therefore, we can use the past to give an indication as to when we should guard against reckless enthusiasm, and when we should be prepared to dip our toes back in the water.

What goes around comes around

A chart showing the Investor Psychology Cycle

The chart above illustrates all the emotions that investors go through, as markets rise and then fall over the course of the economic cycle. Let’s imagine that we decide to invest at the Confidence stage. Prices are increasing, and investors are buzzing with excitement. They are likely to attribute any profits to their own investment skill, and discount the possibility that luck has played a part.

Some investors do not even come off the side-lines immediately, but only enter the market when stories of easily-made profits begin making their rounds (anyone remember the “Technology Boom” in 1999/2000?), and there is increased Enthusiasm to invest. Euphoria can set in, as investors begin to believe that prices can't possibly decline, and detailed fundamental analysis goes out the window. In fact, many investors begin to purchase assets without even understanding what they are buying. Yes, you’ve guessed it, Greed and conviction get in on the act, and is the euphoric pride that comes before the fall.

Then, inexplicably, prices begin to drop off, as some investors start to feel nervous and sell. However, other investors may feel Indifferent and say, "I am not worried because I am a long-term investor", and others may even see the fall as a buying opportunity (Dismissal). Then there is the Denial phase, and prices begin to plummet to levels that once again reflect fundamental prospects. Fear becomes widespread and, at this point, many previously successful investors have not only lost prior profits, but begin to get worryingly close to their initial investment capital.

Desperation and Panic set in followed by complete despair and capitulation, as investors are dumbfounded about how they could have been so wrong. Investors are so emotionally full of Contempt for the situation that the idea of actually buying at bargain-basement levels, or indeed ever investing in shares again, is simply inconceivable.

When the market begins to recover, they are highly Doubtful and Suspicious, believing that the recovery will not be sustained. In fact, any pause in the recovery is seen as the start of a new collapse. Even when it is clear that share prices are fair value, they remain Cautious and reluctant to invest. At some point, they will buy into the recovery story, but may wait until the Confidence stage comes around again before actually buying. And then, the cycle starts again …

So, psychological influences can cause investors to "buy high" during the thrilling and euphoric stages of the cycle, and "sell low" at the panic and capitulation stages.  Buying high and selling low is not a winning strategy, but it takes skill and experience, or a high degree of bravery, to behave counter-intuitively. Or as Warren Buffet once said, "be fearful when others are greedy and greedy when others are fearful."

Where do you think we are in the psychological cycle?

The above news article reflects A J Buckley Asset Management Ltd's current opinion on the subject matter, and should not be relied upon to make any important investment decisions. You should always seek professional advice in relation to your personal financial circumstances. A J Buckley Asset Management Ltd is not responsible for opinions or subject matter put forward on any third party websites linked to from any article in this news section.

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