Seeking Alpha

Investor Psychology

by: Larry Hall
Summary

Psychology plays a key role in investing.

Emotions that affect investing include fear and greed, but are more diverse and can significantly impact results.

Investor psychological profiles affect how an investor's portfolio performs because investing decisions are directly linked to emotions.

Construct a portfolio that meets your investing goals; you can only benefit from comparing your 'profile' to investing strategy.

Investor Psychology & Investment Results

Many market commentators routinely throw around concepts such as ‘Fear and Greed’ and how instrumental they are in the behavior of individuals and markets as a whole. While both fear and greed play a role in individual and mass behaviors, they are part of a much larger set of attitudes and emotions that affects our investing decisions.

I am an investor with a mix of growth/value stocks, high-dividend and traditional dividend stocks. While I do not first consider psychological factors before making an investment, I do try to be aware of how specific traits and tendencies might affect my investment decisions. Whether this awareness helps my investing decisions or not is of course difficult to measure.

The Role Of Emotion in Investing: Graham, Newton and Investor Cargo

Psychology, emotions and irrationality do play key roles in investing. We assume that we are rational beings, but the contents of this blog suggest otherwise.

Established economic and financial theory posits that individuals are well-informed and consistent in their decision-making. It holds that investors are “rational..it’s clear that in reality, humans do not act rationally. In fact, humans often act irrationally in counterproductive, systematic patterns.”

As children, we see the world through a protective lens that protects an exaggerated sense of self. As we grow older, the process of maturation includes developing an awareness of our true ‘size’ in the world.

As many observers have remarked, an investor’s emotional makeup is more important to investing success than intellectual ability or ‘book knowledge.’ This is a simple statement, yet I suspect that most investors disregard its meaning while making their investment decisions.

A smart investor is one that harnesses his or her emotions. The great investor Benjamin Graham, for example, defined intelligent investing in his timeless book “The Intelligent Investor” as a type of applied intelligence that is “a trait more of the character than the brain.”

An inverse proof of this definition is offered in the story of the brilliant scientist Isaac Newton hurling his capital into the speculative South Seas Company, a great growth story of its time. Sadly, South Seas turned out to be a losing proposition three hundred years ago. The ability to define gravity and a series of equally wondrous accomplishments did not make Newton a good investor.

We come to investing carrying our basic experiences, psychological traits, habits and tendencies. Some might call this baggage but I prefer the word ‘cargo.’

The best investors are typically calm and patient, able to set strategic goals and adjust them as needed. They do not panic. They probably also have a good measure of self-esteem and learn from their errors.

Psychological Behaviors That Can Harm Investing Returns

Let’s look at some known emotional traits and behaviors that directly affect investor’s choices and provide a picture of how emotion may intervene in investing. Any of these behaviors can be seen as expressions of investing bias.

Morningstar, altogether a great source for investing research, was my primary source for this section:

Overconfidence is an exaggerated belief in one’s abilities compared to reality. In investing, overconfidence can lead to overtrading. An investor ‘substitutes’ his sense of confidence for actual knowledge, leading to errors and additional commissions and related costs.

Self-attribution is another form of investing bias. People exhibiting this characteristic attribute positive, successful investment results to themselves and bad results to external factors. While emotionally comforting, self-attribution will likely harm returns over time.

Selective memory keeps certain memories and expels others from our consciousness. It can push us to remember our good decisions and forget the bad ones. Selective memory skews the investor’s rear view and encourages overconfidence.

Self-handicapping is a term for investors creating preliminary excuses should an investment go wrong. An example is “the stock did poorly, I must not have done the right research.”

This is another emotional habit that assigns too much power to the investor and distorts buy or sell decisions.

Herding is following the crowd. This can lead to too-casual research or purchasing a stock that is riding on reputation. Running with the herd may also lead to an investor missing out on unsung but sound stocks on the investment landscape.

All of these behaviors are natural expressions of human psychology. None will derail a solid investment strategy and practice by itself. In combination, they are return-limiting. Moreover, an investor indulging in one or more of these habits is likely to repeat them, furthering the damage.

Basic Investor Psychological Profiles (IPPs)

Every investor is unique and has a unique set of emotional predilections and (hopefully) a strategy designed to fulfill his or her strategic investing needs. This interaction is rarely discussed in conversations about investing. Yet it makes sense that an investment strategy meets not just a profile of economic parameters but also ‘fits’ with the investor’s personality.

Here are some sample investor profiles. These are not ‘scientific’ profiles, but are presented to understand how different personality types might match up with specific portfolios. By implication, such a comparison of Investor Psychological Profiles and portfolios is a useful step for every investor to take.

The Aggressive Investor

This investor wants results, and is hard-charging and impatient. He is probably more prone to some of the psychological behaviors we have described than other profiles. This profile is difficult to fit into a long-term strategy that features buying stocks and holding then for long periods of times.

An aggressive investor is a risky investor unless he has a very long time span and can limit impulse buying and selling. Alternately, if adequately self-disciplined he can limit the percent of his securities within his overall portfolio. Almost by definition, this kind of personality is more suited to trading than to investing.

The Flexible Investor

This investor is neither innately aggressive nor defensive; rather, he is pragmatic, open-minded and adaptive. A flexible investor is also someone that naturally avoids syndromes such as overconfidence or self-attribution that promote poor results. People that are pragmatic seem to contain an inherent ability to restrain such impulses.

This profile is probably best matched to a hybrid portfolio that balances risk and rewards. We can visualize a portfolio balanced between growth and value, with solid income (dividends), and bonds and cash for safety’s sake. This is likely to produce relatively consistent results without radical shifts in positions or allocations.

The Defensive (Cautious) Investor

This investor is innately cautious, even timid. Risk frightens him and security reassures him. Even if he is young, the defensive investor is likely to avoid a portfolio heavy with growth or speculative issues. In fact, merely having a high proportion of stocks in a portfolio may cause unease.

The defensive investor will seek out a portfolio that offers maximum security and minimum risk. A portfolio that makes sense for this profile is one with a minority of mostly value or blue-chip stocks and a majority of bonds and additional fixed instruments. Starting out with a more aggressive investment palette will likely drive the cautious investor to modify his holdings in sync with his emotional make-up.

The Nervous Investor

This nervous investor is a different kind of profile. A jumpy investor might be aggressive or pragmatic or cautious, but simply can’t overcome a habit of being anxious. This anxiety almost inevitably leads to poor investment decisions, overselling and frequent changes in portfolio strategy. The nervous investor is really not suited to being in the markets until he learns to lessen the anxiety that causes destructive investing behaviors. Markets stress the nerves of confident people and may inflict real psychological damage on people that are chronically anxious.

The Trader

The trader loves transactions and the rush of the trade. He is looking for short-term gains that he either believes are possible with the right system or market/investment knowledge. The trader is usually quick-witted and may be very intelligent and a good student. Despite or because of these characteristics, he may fall prey to overconfidence. Some traders convince themselves that they are truly investing when they are not. Whether or not that contributes to an excess of confidence, they are not in fact investors. (I include them here because many traders operate in the markets.)

Conclusions

Investing is not an empirical science. It might even be a combination of art and science. Fundamental and technical analyses certainly count. So does investor psychology. While an investor can’t control the movements on a chart or a stock’s fundamental factors such as PE ratio or earnings per share, he certainly can evaluate his or her own psychology.

The most important aspect of investing remains the construction of the right portfolio. It is worth considering whether there is ‘disagreement’ between a portfolio and one’s personal psychology. None of us is a complete or perfect being, and we continue learning throughout our lives. Your portfolio may thank you.

Successful investing to all.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.