Traditional finance and economics assume that everyone is a rational investor, yet in reality every investor is affected by one cognitive bias or another. Today, starting from behavioural economics (Behavourial Economics), we will share two ways human psychology shapes investing performance. Recognising these phenomena lets us analyse our situation more objectively and, in turn, improve our own investing results.
Past Performance and Stock Selection
A study analysing the records of more than seven thousand investment accounts (https://faculty.haas.berkeley.edu/odean/papers/Repurchases/Once%20burned%20JMR.pdf) found that investors' stock choices are influenced by their past investing experience. Compared with stocks they had previously sold at a loss, investors were more inclined to repurchase stocks on which they had made a profit before. They were also more willing to buy back a stock when it was cheaper than the price at which they had last sold it. If investor A sold a stock at a profit and the stock then pulled back to a price lower than the one they sold at, A would be more likely to decide to buy that stock again. Past investing records and the previous selling price affect an investor's decisions — but does this help improve performance? Or might it actually drag that performance down?
An investor's past performance in a particular stock, and the price at which it once traded, should not be the criteria they use when choosing stocks. The factors that move a stock's price — a company's fundamentals, technical indicators, news and so on — are not affected by an investor's past experience. Regardless of whether a stock once turned you a profit, or whether your earlier selling price was below the current one, the stock's future trajectory will not change because of your personal experience.
Past profitable experiences may give us greater confidence in certain stocks, but a stock's past performance cannot be used to predict its future. Concentrating too heavily on stocks we have profited from before, or refusing to buy back a stock simply because its price is higher than the last time we sold, can both cause investors to miss opportunities — overlooking other stocks with the same upside potential, or missing out on a stock's long-term upward trend.
The research team offered an explanation for these two phenomena. An investor's past loss is a painful experience; buying back the stocks that once cost them money brings back the disappointment they felt at the time. When a stock rises above the price at which they originally sold, investors imagine that, had they not sold, they would already have earned a higher return — so buying the stock back makes them more likely to regret the earlier decision to sell. To reduce the disappointment and regret they feel, investors tend to avoid buying these stocks, unconsciously relying on emotion and past experience to make investment decisions, and so losing out on opportunities that might have been profitable.
Behavioural economics research points out that people's decisions are influenced by their own emotions. Rather than purely pursuing a financial return, investors make decisions with the aim of minimising the negative emotions they might experience — unable to analyse the current market trend objectively and rationally, and so missing opportunities or misjudging the trend.
Seeing Only What We Want to See — Confirmation Bias
No matter which strategy an investor uses, they will surely carry out a round of research before making an investment decision. In this process, the investor's own beliefs can shape how they interpret the information, affecting their ability to judge objectively.
Confirmation bias (Confirmation Bias) is a psychological tendency in which people unconsciously seek out more information that supports their own beliefs, and interpret information as evidence consistent with those beliefs. Research (https://www.researchgate.net/publication/330314901_Confirmation_Bias_in_Investments) found that people selectively read more articles supporting their own investment decisions, and in the course of gathering information unconsciously choose to take in more that confirms those decisions. An investor's reading of the news is likewise affected by their existing beliefs or investment decisions. When news reports that "company B is closing its production lines in China", investors who are long the stock may think this will improve product quality and benefit the company's business, while investors who are short may feel it signals rising costs in the future, hampering the company's long-term development.
Under confirmation bias, investors may take in too much information from a single angle and interpret it as evidence in their own favour, becoming overconfident when making or reviewing investment decisions, unable to analyse the situation at hand objectively. Beyond missing opportunities to profit, they may also end up taking a loss.
How to Overcome These Psychological Biases
To overcome the psychological biases that affect investing performance, the first step is to recognise that they exist and to identify how they influence our decisions. After that, we should actively expose ourselves to more information, consider views from multiple angles, and try to step back from our own position — setting aside our existing beliefs for a moment and reading market news and price trends from other people's perspectives. This asks investors to hold an open-minded, critical approach to thinking, to make a habit of revisiting their own decisions, and to become aware of their blind spots and how to correct them.
Psychology helps people better understand human behaviour and thought, and applied appropriately it can bring greater economic benefit to companies and investors alike — its uses include corporate training and sharpening decision-making, among others. TreeholeHK is dedicated to providing professional training for organisations of every size, turning psychological knowledge into practical skills, and has already brought innovation to a range of large enterprises, with training that spans both business capabilities and individual psychology. To learn how psychology can be applied to business and society, you are welcome to browse our corporate section.
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