The psychology of investing
Updated
August 28, 2024
How your monkey brain can lead you to make bad investment decisions.
The key to this is ‘skin in the game’ — a vivid and off-putting phrase. It means exposure to both the risks and rewards of your activities and, of course, it has a big impact on behaviour.
It’s why investment training games don’t work very well. It’s easy to make big gambles with fake money.
When you invest, you’re the only boss and you get very clear feedback on your own performance.
And you can't fire yourself. That forces you to learn about your flaws and either confront or accept them.
Are you hesitant and indecisive or impulsive and rash? Do you panic at the first sign of trouble or are you too stubborn to admit you were wrong?
These are all common parts of human nature and they all have an impact on investing success.
One route is to take some of your own agency out of the equation. Go with a good old market tracking ETF. That’s actually a great answer if you don’t have time or desire to develop your investing skill. It doesn’t immunise against systemic market risks but it does go a long way to immunising against personal error.
The great George Soros, a huge advocate of separating emotion and investing, said “if you’re having fun, you’re probably not making any money. Good investing is boring”. This approach totally marries with that.
However, if you want more discretion over your investing, it’s also worth trying to manage your flaws and emotions to improve your investing. Honestly, it’s worth doing in its own right!
Accountancy-driven rules like Ben Graham’s can be good ways of formalising your investing behaviour. It can also be helpful simply to diagnose them.
Let’s look at some of the most common investing weaknesses or as we’re exaggerating them:
This one’s a killer — especially when it’s about your first investment.
Investing isn’t for absolutely everyone — especially if you want to use your money in the short term. But, at least from personal experience, there are far more people who have a nagging desire to start but are putting it off, than people who’ve consciously decided not to.
To give a shout-out to, erm, ourselves we do remove a lot of the barriers to starting up. No expensive charges, paperwork or convoluted platforms with us. But ultimately, only you can fix procrastination. And like all procrastination, it means just gritting your teeth and getting on with it.
A similar behaviour is focusing on missed opportunities. Annoyed at not having taken what turned out to be a perfect decision, you obsess about it or refuse to take it now because it’s psychologically tarnished. This is very common among people who miss bull markets.
We also tend to remember our big misses more than the times where the decision wouldn’t have worked out.
Try to consider the decision on its own terms today, rather than in relative terms.
Did you grow up smashing a lot of controllers after losing at FIFA?
Rash, impulsive decisions may be your weakness.
Every investment in the universe fluctuates. Panic selling at the first negative sign or price drop is a good way to make sure you lose on most of your investments.
A more subtle mistake is cutting your returns early.
Rather than total performance of their investments, many people make a binary distinction between wins and losses, categorising their investments by “was I right/smart?”.
This can incline you to sell to lock in a profit quickly for the psychological payoff of a right choice and miss out on further growth.
The opposite but just as (if not more) dangerous is…
The worst combination of behaviours is rashly cutting your wins and then stubbornly running your losses. It’s obviously self-destructive but very psychologically tempting. Many people hate losing more than they enjoy winning and subsequently they’ll do anything to put off a loss.
There are a whole bunch of tricks and biases people use to avoid changing their minds and recognising the loss, from ignoring the facts to upping their risk to cancel out the deficit.
Phrases like, “It’s only a loss if you sell” are technically true but also technically massively unhelpful.
Being steadfast is actually a good thing in investing — you shouldn’t necessarily switch your strategy just because things don’t immediately play out as expected. But when the facts of an investment change, don’t be afraid to change your mind.
Especially if you’re new to investing, it can be tempting (and time-saving) to delegate your decisions to following a more experienced friend or acquaintance.
Again, it’s not a bad idea to learn from a veteran investor. But don’t just blindly follow. Do your own research. And definitely don’t make decisions based on your attachment to that person.
You shouldn’t be investing for fun. Fun can be a side effect of developing your skill or achieving success, but it shouldn’t be the main output. If it’s primarily a recreation, it’s gambling.
If you really want to gamble, that’s up to you. But it’s a bad idea to conflate, “I’m enjoying this” with “I’m good at investing.”
It’s the irritating modern phrase that’s also a timeworn investing behaviour! FOMO is a classic aspect of bubbles. It’s painful to see others getting rich quick. That’s just a fact.
This one’s particularly insidious because resisting FOMO means sometimes you might miss out on something big AND real. But often FOMO investors enter frothy assets just as the early investors are cashing in their returns and they end up holding the (flaming) bag.
It’s not a bad thing to learn from others’ lead, but if you truly believe an investment is dumb, don’t buy it just because you think everyone else is dumb too.
Almost all of these flaws are excessive versions of what could be reasonable behaviour in moderation.
The point isn’t to work out your weaknesses and just do the opposite. Flawed emotions can sometimes lead to good outcomes. For example, sometimes stubbornness will keep you holding onto a sinking stone, other times it’ll keep you in a good thing. FOMO during the internet bubble could have got you into Amazon or Pets.com.
But in any case the decision shouldn’t have hinged on those emotions.
The point is to discover your inclinations, isolate your emotions and make sure they’re not controlling you. It’s like being a Jedi, but with less disappointment and Yoda doesn’t burn your library down.
Remember, humans are amazing at post-rationalising to themselves and you will try to disguise your emotions in respectable logic. Filter bubbles (yay, 2017) are also a big problem in investing — if you only read investment advice that makes you more certain, stop that! If you’re a crypto investor, don’t get all your advice from r/Crypto.
Take time to make the decision, then take time to cross-analyze why you made it. And once it’s made, follow through.
And if that all sounds like way too much work: seriously, there’s still that passive ETF.
Today, we’re tackling the most important aspect of investing.
We can talk about strategies and data, but the truth is the biggest challenge is managing your own emotions.
Many economists used to work on the assumption that investors always act rationally with the information they have at hand, at least collectively.
Almost all recent psychology would imply the opposite: humans are much more driven by ego and the narratives we write for ourselves than dispassionate calculation.
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