How Human Psychology Shapes Your Investment Strategy

Investing is often perceived as a numbers game where rationality and logic reign supreme. However, human psychology plays a significant role in how we make investment decisions. Understanding the psychological factors influencing our investment behavior can help us make better choices and avoid common pitfalls.

Risk Tolerance and Decision Making

One of the most critical aspects of investing is understanding your risk tolerance—your ability to endure losses without losing sleep. Risk tolerance varies from person to person and can be influenced by factors such as age, income level, and personal experiences. Investors with a high-risk tolerance may be more inclined to invest in volatile markets or alternative investments, while those with a low-risk tolerance, or even with loss aversion, may prefer safer, more predictable options.

However, even those who consider themselves risk-tolerant can fall prey to emotional decision-making. Fear of losing money can lead to hasty decisions, such as selling off investments during a market dip, which may not be in your best long-term interest. On the other hand, overconfidence in a booming market can result in taking on more risks than one can handle, leading to potential losses when the market corrects itself.

Psychological Biases 

Psychological biases are systematic errors in thinking that can affect decision-making. In investing, these biases can lead to suboptimal choices that may harm your financial outcomes. Two particularly impactful biases in the world of investing are the endowment effect and anchoring bias.

The endowment effect is a cognitive bias where individuals assign more value to things simply because they own them. In investing, this can manifest when an investor overvalues a stock or asset in their portfolio because it’s familiar or they have a personal connection to it. This attachment can lead to a reluctance to sell, even when objective analysis suggests it’s time to move on. 

Another common bias is anchoring, where decisions are heavily influenced by an initial piece of information, even if it’s irrelevant. Investors might anchor their perception of a stock’s value to its past performance or to a comparison with a different asset rather than evaluating its current fundamentals. 

Both of these biases can cloud judgment and lead to decisions that are not based on sound financial analysis. The key to overcoming biases is self-awareness and a commitment to objective research. 

The Comfort of Predictable and Familiar Investments

Many investors stick with what they know, preferring comfortable, predictable investments like government bonds or blue-chip stocks. This preference can be attributed to the psychological phenomenon known as the “status quo bias,” where people tend to prefer the current state of affairs and avoid change. While there’s nothing inherently wrong with favoring low-risk investments, this mindset can limit growth opportunities and prevent diversification, which is crucial for long-term financial success.

Confirmation bias is another psychological factor that can affect investment decisions. This bias leads investors to seek out information that confirms their existing beliefs while ignoring or downplaying evidence that contradicts them. For example, if an investor believes that a particular stock is a good investment, they may focus only on positive news and disregard warning signs, leading to potentially poor investment choices.

Herd Behavior and Following Trends

Herd behavior, or the tendency to follow the crowd, is a common occurrence in investing. Investors often feel a sense of security in numbers, believing that if others buy or sell a particular asset, they should do the same. This behavior can lead to buying into market bubbles or selling off during market downturns, both of which can be detrimental to long-term investment success. It’s also quite common to follow the herd after the opportunity has already passed. 

The fear of missing out (FOMO) is a powerful driver of herd behavior. When investors see others profiting from a particular trend, they may feel compelled to join in, even if it doesn’t align with their investment strategy or risk tolerance. This can lead to impulsive decisions that are not based on sound financial principles.

The Dangers of Personal Connections

Personal connections can also significantly influence investment decisions, often leading to a misplaced sense of trust. This occurs when investors rely too heavily on the recommendations of someone they know, such as a friend, family member, or even an acquaintance with a convincing story. The trust generated by these personal connections can overshadow the need for independent research and critical analysis.

For instance, you might be more inclined to invest in a product because a friend’s mother recommends it or because a trusted colleague raved about a particular investment opportunity. While these connections might provide a sense of security, they can also make you more vulnerable to making decisions based on emotion rather than fact. Always take the time to perform your due diligence, regardless of how trustworthy the source may seem.

Exploring Alternative Investments

For those looking to break away from traditional investment options, alternative investments, such as real estate and mortgage funds, offer an attractive opportunity. These investments often provide diversification and the potential for higher returns, making them a valuable addition to a well-rounded portfolio. Unfortunately, they can go against some of the biases mentioned above. If you’ve never invested in an alternative asset, it is unfamiliar. Similarly, if you don’t know anyone who has had success in alternatives, you may hold a negative bias towards them.

Mortgage Investment Corporations (MICs) are an example of an alternative investment that allows investors to gain exposure to the real estate market without directly purchasing property. This can be an appealing option for those seeking stable, income-generating investments with the added benefit of diversification while investing in a more familiar alternative investment through something more familiar: the real estate market. To learn more, contact Jordan on our team today.

Understanding the psychological factors that influence your investment decisions can help you make more informed choices that align with your financial goals. Whether you prefer the comfort of predictable investments or are open to exploring alternative options like real estate and mortgage funds, understanding your psychological tendencies can help you make better decisions and achieve your financial objectives.