Stock market psychology and investment decisions
Investors are human beings, not robots, and are swayed by emotions such as fear or excitement. In the realm of investing, this can be a significant issue.
When a portfolio is performing well, there is an incredible sense of exhilaration. Outperforming the average can make investors feel invincible. However, without the emotional lows that the market can cause, these highs would not be possible.
Ignoring one's intuition when investing
Many key factors drive market fluctuations, and investors need to be aware of these to thrive in today's volatile environment.
Multiple factors influence the market
Interest rates are a driving force behind the movement of stock and bond markets. Rising interest rates have a detrimental effect on bond prices and can suppress stock prices. Unfortunately, many average investors underestimate the impact of exchange rate changes on their investments until the aftershocks are felt.
Similarly, the global 24-hour news cycle and the speed of information dissemination can increase market volatility and lead to exaggerated reactions. The relentless focus of news agencies on global events can create an atmosphere of instability for many.
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Essentially, the psychological aspects of investing can greatly influence the outcomes of financial markets on both individual and collective levels. While the combined effects of emotion-based investment decisions and market volatility can potentially have a negative impact on returns, investors can make sound investment decisions through certain methods, thereby potentially enhancing their portfolios in any stock market environment.
Emotion-based investment decisionsIn most cases, individual investors who allow their emotions to dictate their investment decisions will suffer from poor long-term performance. In my view, average investors will experience two types of emotional responses.
The first emotion-driven decision comes from the "Fear of Missing Out" (FOMO). These investors will chase after well-performing stocks to avoid missing out on the opportunity to make money. This leads to speculation without considering fundamental investment strategies. Investors cannot afford the burden of "the next big craze," or they may be left with worthless stocks when the craze subsides.
FOMO can lead to speculative decisions in emerging areas that have not yet been established. An example of this is the recent cryptocurrency craze. Many investors may worry that their colleagues and neighbors will "get rich quick" without them, and they chase after cryptocurrency stocks with unproven business models. As rational behavior begins to emerge and the stocks of cryptocurrencies plummet, inexperienced investors are left high and dry.
Another emotion that investors often face is the fear of losing everything (FOLE). While investors do not want to be left out, they are more concerned about the fear that they will lose their entire investment. When market turmoil leads to significant fluctuations in the stock market, people may become uneasy, leading them to put their investments on the sidelines to avoid heavy selling or a stock market crash.
This behavior was most evident after the 2008 financial crisis. In response to the market sell-off, investors withdrew their funds from the stock market, only to miss out on the opportunity to recoup their losses during the sharp recovery.
Hating to lose money can cost you dearly.
The collective impact of stock market fluctuations.
The 24-hour news cycle exacerbates irrational, emotion-based investment decisions, as information spreads almost instantaneously, largely thanks to the internet. Since major global stock markets overlap during market trading hours, investors' reactions to global events are reflected in real-time. When this reaction is particularly negative, it can create a domino effect of selling across regional stock markets, and the cycle of market adjustments and news updates seems endless.
Unfortunately, selling leads to more selling, which can lead to a downward momentum of stocks that is difficult to fall during market adjustments. The exaggerated moves of market turmoil can shake the confidence of inexperienced investors who fear they will lose the funds they have worked hard to accumulate.
Adding complexity to short sellers are professional short sellers, such as hedge funds or algorithmic trading programs, which can capitalize on selling situations by shocking investors with a significant amount of additional selling pressure.Methods for Making Sound Investment Decisions
Throughout the history of the stock market, no investor has ever broken through with an investment of 1.000. While the general rule of thumb is to avoid making emotionally-driven decisions, investors should also not follow speculative "get rich quick" trends.
Diversification, Diversification, Diversification.
One of the most important fundamental principles for any investor is to diversify their investment portfolio. Skilled investment managers aim to achieve a balance between sectors to realize the best risk-adjusted portfolio returns. Diversifying the investment portfolio can mitigate downside risk. Typically, it is advisable to completely avoid speculative industries, but if an investor wishes to venture into riskier areas, they should limit their exposure to a few percentage points of the total portfolio.
Stagger Buy and Sell Decisions.
Another strategy that investors can use to limit emotional investing is to stagger their buy and sell transactions. For instance, if an investor wants to own 500 shares of a particular stock, a prudent approach might be to purchase 200 shares at the current price.
The next purchase order could be placed at a price 5% to 10% lower than the current level, and the remaining shares could be bought at a price 20% lower than the current level. If the stock price rises after the initial transaction, the investor will still benefit from the 200 shares and may have the opportunity to continue with the next investment, thus alleviating some of the FOMO effect.
If the price falls, the investor will acquire more shares at a lower price. The same method should be used when establishing stock selling points. Instilling this discipline and trading method can enable investors to better manage their portfolios and achieve higher risk-adjusted returns in the long run. If a stock falls due to the failure of a company or sector, it was not a good investment thesis from the outset. If the thesis has changed before the initial transaction, it is best to avoid making the first purchase or to minimize losses.
Have a Solid Investment Approach.
Lastly, having an investment approach that helps combat emotions is crucial. Dividend-paying stocks can be an important tool to help investors avoid emotional decisions. They are typically less volatile and often more resilient in challenging market environments.Additionally, limiting exposure to commodity-centric stocks (such as oil and precious metals), which can be more volatile and heavily influenced by geopolitical factors, should help investors avoid emotionally driven reactions.
Investor Bottom Line
It is important to have a rational and feasible investment argument based on objective indicators rather than speculation. Adhering to a strategy will guide investors during periods of volatility and help resist the impulse to panic sell during corrections or chase unsustainable levels of hype.
Patience is crucial, and investors who remind themselves of why they are investing can better control their emotions. At the same time, identifying when to change investment strategies requires an objective approach. By combining these simple steps and avoiding emotional decision-making, it is almost certain that, over time, this will lead to better outcomes for investors.