The Psychology Of The Stock Market
Seeking Alpha Analyst Since 2014
Investment professional based in New York City with extensive experience across public and private markets. Dartmouth College grad and CFA charterholder. Passionate about markets, business, and behavioral finance.
Summary
- In investing, psychology is as important as accounting. Aim to understand your thought processes to identify potential investment mistakes before they happen.
- A common type of human error is the "anchoring effect." It relates to investors' failure to update their expectations.
- Other important behavioral biases include loss aversion, confirmation, and endowment biases. The best investors are good at mitigating these biases.
In my last two articles, I described some reliable ways to lose money in the stock market. Most of those money-losing situations arise from two main psychological causes that can be prevented or mitigated – cognitive errors and emotional biases.
Cognitive Errors – Anchoring Effect
A cognitive error occurs anytime your brain does not process information correctly. Previously, I gave the example of an investor that sells NVIDIA (NVDA) stock too early, only to see it rise asymptotically.
What caused this mistake? Perhaps the investor bought NVDA at $35 with the intention to sell once he doubled his money. In this case, the $70 price target was the “anchor.” The investor effectively programmed his brain to sell once he saw that number on his screen. By doing so, the investor blinded himself to developments that made the "anchor" irrelevant. He failed to update his expectations and made a bad choice.
The “anchoring effect” also occurs when investors look at a stock’s historical price range to determine a stock's worth. For example, suppose it is December 2019. A beginner looking at the WPP price chart below sees that WPP’s price of $70 is significantly below its most recent high of $118 in Feb 2017. Thus, the beginner might assume that WPP’s stock price will eventually revert to $118, the anchor.
Although such reversion can happen, I believe that it is unlikely in WPP’s case. WPP is an advertising agency whose main business has been disrupted by Google and Facebook’s digital advertising models. The $118 price is anchored to expectations that correspond to a very different world.
To mitigate the anchoring effect in such scenarios, one must remember that stock prices depend on their context. Keep your perspective fresh by following the news and understanding that seemingly tangential headlines can have a profound effect on stock prices.
Emotional Bias – Loss Aversion
You might harbor emotional biases that may consistently lead you to make bad investment decisions. A common emotional bias is “loss aversion.”
Loss aversion is the human tendency to avoid losses, even at the expense of potential gains. For example, suppose that it is February 2020 and you just bought Macy’s (M) at $17. Shortly thereafter, the market crashes, as investors sell their stocks in anticipation of the economic impact of the COVID-19 pandemic. You are unwilling to sell Macy's at a massive loss.
A couple of months later, Macy’s stock pops up to $9, as investors anticipate a re-opening of the economy. You are thrilled, as you have recovered a portion of your investment. Yet, you are still unwilling to realize a loss.
A few weeks later, reports emerge of an increase in coronavirus cases, putting the economy’s re-opening in peril. Macy’s stock falls back down to $6-7. As a wave of retail bankruptcies emerges, you question your decision to hold Macy’s. You are now in a bad situation – Macy’s may never get back to $17. To make matters worse, you have missed out on other opportunities because your money was tied up on Macy’s. How could you have prevented this situation?
First, recognize that this situation arose from loss aversion bias. You decided that you cannot lose money on this trade, so you underweighted the tangible possibility of further loss (e.g., a Macy’s bankruptcy) and overweighted the remote possibility of a quick recovery.
Second, think of your portfolio as whole. Do not mentally account for stocks as “individual trades.” In this case, you could have cut your losses earlier and used the proceeds to buy a stock that would benefit from work-from-home trends. Although cutting losses hurts initially, the subsequent gains will assuage your pain.
Emotional Bias – Endowment and Confirmation Bias
Previously, I used the Johnson & Johnson (JNJ) example to illustrate the occasional need to sell your favorite stocks. On hindsight, selling JNJ at $155 was the right call. But at the moment, selling was a difficult decision to make. Why?
Generally, investors think that something they already own is worth more than something they do not (“endowment bias”). In the JNJ case, I would have never bought it at $155, or even at $150. But because I already owned JNJ, I felt that the stock was more valuable than it really was.
One can mitigate endowment bias by imagining himself as a potential buyer. The question now becomes: at what price would one buy a stock if one did not already own it? If that price is significantly lower than the current price, then selling could be a good option.
Curiously, I mostly remember the reasons for holding JNJ – namely, the strong credit rating, a dividend raise, and the company’s work on a COVID-19 vaccine. This points to “confirmation bias,” as I may have been subconsciously looking for a justification to continue holding one of my favorite stocks, while ignoring the evidence pointing to the contrary.
To mitigate confirmation bias, I find it helpful to draw up a list of pros and cons for an investment. If the list of pros is materially longer than that of cons, you might be subconsciously looking for reasons to make the investment. Once aware of the bias, you can compensate by consciously looking for more cons.
Conclusion
In investing, psychology is as important as accounting. And while a lot has been written about accounting, not a lot has been written about the psychology of markets. Thus, if you understand your individual psychology well enough, you are probably ahead of many other investors.
We have now covered common investing mistakes and their psychological causes. In the next article, I will give practical advice on making your first stock market investment.
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