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The Importance of Psychology in Investment Decisions
What is psychology in investment decisions? That’s the question on so many people’s minds.
As time passes, researchers have noticed a rise in psychological factors that affect investment decisions. The investor’s psychology greatly influences his or her behavior in investment decision-making. For example, investors in Turkey are seen to be emotionally favoring their own trading opinions. Such investors are less likely to be able to objectively evaluate the risks and returns of a company. This is mostly because of their tendency to follow their gut feeling or behave according to market sentiments. So, understanding these psychological factors behind investments can be useful while helping an investor make the most efficient investment.[1]
So, in this article, we shall discuss the importance of psychology in investment decisions.
Investment Decision-Making Affected by Psychology: Psychology in Investment Decisions
Over the years, experts have noticed a growing trend in the relationship between psychology and investment decisions. Careful research showed that the investor’s psychology is often linked with the risk and return of their investment. In the stock market, a higher risk is associated with a higher return and vice versa. But unlike experts, an investor doesn’t have the ability to evaluate the return and risk accurately. So, they are expected to act emotionally when making an investment decision. Their financial decisions are made on the basis of their personal opinion of the market.
According to some analysts, managing risk perception involves making the investors aware of the outcome of their investment decisions. In this way, they can have a better understanding of the risks and returns, and make better financial choices. It has been observed that an investor who indulges in high returns has lower risk perceptions. Similarly, a person who tries to avoid risks at any cost is known to have a much higher risk perception.[2]
Analysts familiar with Behavioural Finances in Turkey have stated that investors should be objectively aware of the market to evaluate the risks and returns. This will allow them to make sound investment decisions in financial management. However, to understand the psychological factors that influence investor’s decisions empirical studies are being held. So far, it has been observed that framing is one such impactful factor. Framing on the basis of risk evaluation has an effect on the tendencies of an investor to make different financial decisions. Currently, the analysts are working on measuring the risk propensity of investors, and the risk evaluation that affects their decision making.[3]
Behavioral finance specialists have also claimed that several external factors, such as feelings, moods and sentiments, risk perception, personality traits, and attitude and emotions play an important role in this. All of these factors are responsible for building an investor’s preferences, also known as behavioral biases. These behavioral biases can be further broken down into heuristic biases and cognitive biases. Heuristic biases lead to tendencies such as representativeness, availability, and anchoring. However, cognitive biases can cause an investor to be overconfident, overreact to situations, or show risk aversion. These heuristic and cognitive biases ultimately shape an individual’s psychology that affects his or her investment decision process.[3]
Factors Affecting Investment Decisions
Although it has been deemed relevant, preparing a demographic profile based on investment decisions is no easy task. However, ongoing studies on the complex task of the investment decision process identify and measure the emotional factors that have significant effects on the investor’s psychology. From the studies that have been made, financial analysts have been able to draw the following inferences.[4]
- Investors tend to have different approaches to positive and negative returns. While their reaction to profits (positive return) is more stable and neutral, their reaction to loss (negative return) is hostile and extreme. So the psychology behind a more aggressive reaction towards losses affects their investment decision process.
- As mentioned earlier, framing is an important regulator of investment decisions. And the way financial information is framed or presented can have varying results. Symmetrical information of the market and evaluation of risks and returns helps the investor to make a financial decision.
- A relationship that exists between the risk evaluation and investment decision has already been mentioned. Investors have shown higher risk aversion when they have perceived higher risk, than when they perceive lower threats or risks in investment decision-making.
- Investors with the tendency to higher risk tolerance have been seen to accept risky projects with the prospect of a higher return. Investors with higher risk perception however accept projects that face lower risks.
- Framing in terms of profit or losses is also in sync with risk perceptions. If there is asymmetrical information available to the investors, it affects their ability to perceive risks due to limited or uneven information.
- Risk perception in itself is an important psychological factor affecting financial decisions. The effects of risk perception have a direct role to play in the investment decision process.
- The different investment decisions shown by the investor have also pointed at the income of the investors and their education.
- Other than these economic factors, five other emotional factors were observed in the studies, which affected the investment decision. These were indecisive emotion, paranoid emotion, dogmatic emotion, clueless emotion, and enthusiastic emotion. All these factors contributed to a significant influence upon the mind of the investor.
Conclusions and Final Words on; “Psychology in Investment Decisions”
So, understanding the investor’s psychology becomes all the more relevant when discussing investment decisions. Framing of information and risk perception are the most common factors that affect the investor’s psychology and behavior. The psychological studies conducted have shown the possible outcomes related to the importance of psychology in investment decisions. Analysts are working on associating and combining these factors with more personal mediators; such as heuristics and emotional biases to further understand an investor’s psychology. These are unavoidable psychological and emotional factors that influence the investment decision process. The investor’s mood and personal sentiments must also be considered an important regulator while making an investment decision. Analysts believe a better understanding of these factors will result in a better appreciation o the investors, and this will potentially help them make a better investment decision.[5]
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References
- Riaz, L., Hunjra, A. I., & Azam, R. I. (2012). Impact of psychological factors on investment decision making mediating by risk perception: A conceptual study. Middle-East Journal of Scientific Research, 12(6), 789-795.
- Shehata, S. M., Abdeljawad, A. M., Mazouz, L. A., Aldossary, L. Y. K., Alsaeed, M. Y., & Noureldin Sayed, M. (2021). The Moderating Role of Perceived Risks in the Relationship between Financial Knowledge and the Intention to Invest in the Saudi Arabian Stock Market. International Journal of Financial Studies, 9(1), 9.
- Madaan, G., & Singh, S. (2019). An analysis of behavioral biases in investment decision-making. International Journal of Financial Research, 10(4), 55-67.
- Civek, F . (2019). The Effect Of Investors’ Cognitive Bias On Stock Decision Making. Quantrade Journal of Complex Systems in Social Sciences, 1 (1), 13-21. Retrieved from https://dergipark.org.tr/tr/pub/quantrade/issue/49567/635651
- Ricciardi, V. (2008). The Psychology of Risk: The Behavioral Finance Perspective. In Handbook of Finance, F.J. Fabozzi (Ed.). https://doi.org/10.1002/9780470404324.hof002010
