THE psychology
behind stock
market investing
In order to be a successful stock market investor, we must
understand the core psychological and emotional drivers
of both the stock market and its individual investors,
writes Michael Kodari.
M
any classic
finance theorists
have based their
assumptions on
the ideas that markets are
perfectly efficient and are
composed of investors who
all make informed and
rational decisions.
On the other hand, many
industry professionals
acknowledge that this is not
always the case.
Fear, greed, emotional
attachment and herd
mentality are all key factors
that can cause many stock
market investors to make
irrational investment
decisions, which stray
away from their investment
strategy and subsequently
have negative impacts on
overall performance.
To deal with this,
investors need to stick
to a sound and proven
investment strategy. They
must first understand what
type of investor they truly
are, how emotions affect
individuals and the market
as a whole, and how to
make informed rational
38 | new wealth creator SUMMER 2014
decisions, independent
of what others are doing.
“Be fearful when others
are greedy and greedy
when others are fearful.”
- Warren Buffet
“stick to
a sound
and proven
investment
strategy.”
Fear and greed
The emotions of fear and
greed are the two main
drivers of irrational decisionmaking. The most obvious
example is when these basic
instincts lead investors to
go against one of the most
fundamental rules of stock
market investing: “buy in
gloom, sell in boom”; or buy
low, sell high.
Greed can lead to
investors buying shares at
all time highs, and at prices
that may be well above the
investor’s personal valuation
and pricing beliefs. This is
due to the fact that people
do not want to miss out on
returns and will therefore
pay extremely high and
inflated prices, and will
also buy into stocks they
may have never considered
at lower, more reasonable
prices. When stock prices
are at all time highs, the
chances are that there
may be more downside
risk, compared to upside
return potential; and this is
something investors must
always keep in mind.
This powerful emotion
can also lead some to forget
about their risk tolerance
and go on to invest in
speculative high-risk
companies, which may
be totally contradictory
to their initial investment
goals. When this happens,
investors forget to think
about how much they are
prepared to lose, and only
focus on the potential for
extremely high returns.
On the other side of the
spectrum, fear can also lead
investors to make irrational,
uninformed decisions. Many
investors will buy shares
which they believe have good
growth potential and are
well-priced, but when the
market experiences shortterm downturns, fearful
investors will sell out a loss,
even though nothing may
have changed in the stock’s
fundamental true value.
In this type of scenario, a
more rational value investor
would see this as an even
better buying opportunity,
where he or she can buy the
stock at a more promising
risk to return ratio.
These emotions of fear and
greed also play a huge role in
creating short-term market
volatility. This volatility is
caused by the overreactions
towards positive and
negative announcements
and expectations, along with
an overall herd mentality
that can cause large swings
in stock prices.
“Too many investors are
bullish at high prices, and
bearish at low prices.”
Herd mentality
Don’t follow the crowd.
Another psychological trait
that can affect the investor’s
decision-making process
is the idea of ‘following
the crowd’. When making
decisions solely based on
what the majority of the
market is doing, investors
often forget their initial
investment objectives and
purely assume that they
themselves must be wrong.
The only time when this
type of behaviour can be
beneficial is if an investor
is able to predict market
sentiment for a particular
stock or sector, and utilise
an entry and exit strategy
where he or she is able to
both get in and out before
the majority. We must keep
in mind that this is more of
a short-term gain strategy,
and cannot be relied upon
in the long-term.
Emotional
attachment
Becoming emotionally
attached to a particular
company or sector within
the stock market can cloud
an investor’s decisionmaking process. This can
quite often be the case
with more speculative
shares, when investors
continuously hold onto
stocks which experience
earnings downgrades
and poor exploration
announcement in the hope
that things are bound to
CNN Money Fear and Greed Index, calculated from 7 different market indicators
“DO NOT LET YOUR
OWN EMOTIONS CLOUD
YOUR JUDGEMENT OF
INVESTING DECISIONS.”
get better. At the same time
some investors have the
mindset that as long as
they have not sold out of
their positions, they have
not actually made a loss.
In these types of situations
investors may be better off
accepting their losses, in
order to stay aligned with
their investment strategy.
Tips to use stock
market psychology
to your advantage
• Identify what type of
investor you are (risk
aversion, time horizon and
investment objectives).
• Find a solid investment
strategy which aligns with
your investor type.
• Use the basic notions of
fear and greed to buy low
and sell high.
• Do not let your own
emotions cloud your
judgment of investment
decisions.
• Follow a sound investment
strategy and stay away from
the ‘herd mentality’.
Ultimately the most
successful investors are
those who are able to
consistently make rational
and informed decisions
based on solid facts,
research and information,
without letting their basic
human psychological
emotions come first.
To this end, they can
differentiate themselves
from the masses, potentially
achieving superior results
by centralising investments
around a sound strategy.
Michael Kodari is managing director
of Kodari Securities (KOSEC).
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