Behaviour, Psychology & Reasoning

Behaviour, Psychology & Reasoning

Investment Optimisation

Behaviour, Psychology & Reasoning

Establishing an understanding that investment markets are not perfect will create an awareness that you are likely to experience a range of emotions over your investment journey. It is these emotions when faced with limited or unknown information that heightens your tendency to formulate and act on mental shortcuts (heuristics) and when led by inaccurate information, judgments, and beliefs, the result is cognitive bias.

The mental shortcuts and biases affect investor behavior, markets and trading psychology, cognitive errors, and emotional reasoning.

1. Investment Behavior

Overconfidence, excessive optimism, self-attribution bias, framing bias, and loss aversion often lead investors astray and can lead to harmful investment decisions. At the start of your investment journey, managing and limiting these behavioral biases is crucial as all of these factors lead to irrational rather than well-considered investments ideas and strategies. You want to avoid at all costs the old saying “once bitten, twice as sky”. This is where a trusted adviser or coach can help.

2. Emotional Reasoning

Emotional reasoning is when you interpret feelings as proof instead of basing your conclusions on facts. Aron Beck, a founder of cognitive behavioral therapy, coined the term emotional reasoning and summarised that many people (investors) believe that their mental shortcuts (heuristics) and biases are examples of sound, scientific reasoning and therefore should be trusted for decisions (investments). Many investors are surprised to learn that they are emotional, not logical.

You’ve likely heard the saying “trust your gut.” Well, this isn’t a one size fits all approach. Life and investing is a little more complicated to navigate than this saying portrays it to be.

Emotional reasoning in many circumstances leads a person to blatantly ignore any factual evidence, or at the very least forget to look for any factual evidence.

Emotional reasoning can alter a person’s perception negatively, leading them to make poor investment decisions. When we base reality on our feelings rather than facts, we are headed for trouble! Emotional reasoning, a cognitive distortion, blurs people’s perception of reality and often causes people to act in detrimental ways.

By separating emotion from reality and In identifying that your behavior and emotions are guided, created and further solidify your own biases towards investing. You can start to create awareness of your own emotional reasoning, thus improving your own ability to identify when you are more likely to be prone to an irrational investment decision.

3. Market & Trading Psychology

Stock market psychology refers to the ability to identify and manage emotions and behaviors that may arise when investing (trading). The stock market is generally viewed as a forward-looking indicator of expectations and perceptions around a company or sector’s performance, however, markets are often swayed by factors that influence trading psychology on an individual basis and at a collective level.

Trading psychology refers to the mental state and emotions of an investor that determines the success or failure of a trade/ investment transaction. Assumptions heuristics (mental shortcuts), such as anchoring bias, loss aversion, and confirmation bias, or making an investment decision based on one positive result, can result in outcomes that are less than desirable.

Heuristics, both human and financial coupled with biases affect economic markets, this is the result of the collective impact of independent decisions made by millions of people, acting for themselves, on behalf of others or as professional investment managers. As a result, many markets, industries and asset classes are not successful for many years. Understanding what causes these anomalies in valuations of individual securities, asset classes and stock markets can result in better market performance and gaining access to beneficial opportunities.