An introduction to investor psychology

Behavioral finance, neuroeconomics and psychoanalysis try to fill in the gaps of classical economic theory and explain stock market anomalies.

One of the most important factors for the function and effectiveness of stock markets are the investors themselves, especially their decisions and actions. These actions depend on their psychology, which is formed by several factors.

Questions Answered

Investor psychology’s theories try to answer questions like which are their motives, if there is a rationale, how decisions are made, how mass affects them, which way market anomalies are caused. It tries to explain phenomena that cannot be interpreted by the classical economic theory.

Behavioral Economics

One of the fundamental theories of behavioral economics is prospect theory. It supports that people consider the events that have little possbilities to happen as unlikely, while they take for granted those with high possibilities. Moreover, there is a reference point for each investor, which is different for every single stock, regardless of their possible interaction. Below this point they tend to risk, whereas for revenues above it they avoid it.This is called anchoring and means relying heavily on a certain trait, while assesing something, ignoring others. Moreover, when one has to make a decision he takes losses into consideration twice. It is called “loss aversion” and it explains the phenomenon of selling profitable stocks quickly, as well as keeping non profitable ones.
Other psychological factors that play vital role in investor’s behavior are self-control and regret. Self-control is about avoiding the urge for instant satisfaction of needs and the will to abandon stocks that cause loss of money. Regret is the most relevant sentiment to decision making. It refers to experiencing pain and frustration after having made a mistake. This explains the postponement of selling penny stocks, since the investor tries to avoid the feeling of regret for having bought them.

Another significant theory in behavioral economics is the role of self-confidence. The combination of optimism and confidence results in paying too much attention to personal judgement, underestimating risks and ovverating personal abilities. This often ends in bubbles or great trading volume.

Neuroeconomics

This field of psychology and economics describes the study of neuronal function in decision making and future predictions. It claims that behavior is a result of the function of the central nervous system and identifies the exact parts of the human brain that are activated in different tasks and how they interact to each other. Its surveys found out that people regard money like food or drugs, as far as reward is concerned. This means that they provide direct feedback, even if they are not spent. It also studies subjects like selective attention when there are many external stimuli, compliance, expectations and beliefs about skill and talent.

Psychoanalytical theory

Another important theory in investor psychology is about the role of the subconscious for the interpretation of economic behavior of people. It pays attention to motives like imagination, irrationality of id (subconscious) and the effort to balance ego, superego and id. Furthermore, it introduces the concept of collective unconscious, the experiences of previous generations, stored in memory, which are mutual to human. Moreover, it combines psychoanalyticla terms to mass psychology theories.