Have you ever heard of the psychology of money? It is that science that attempts to analyze the investor’s mindset and the psychological conditions that influence his financial decisions.
According to psychological studies, the individual does not always make rational decisions – contrary to traditional economic theory – but rather makes irrational decisions under the influence of everyday psychological conditions.
In a report published by “Investopedia” (Investopedia) American investment affairs writer, Adam Hayes emphasized the importance of the psychological state of the investor and pointed out that each person lives in different situations, social life is a dynamic process that includes many variables. For this reason, many people do not act rationally when exposed to uncertain and dangerous situations, and their emotions and prejudices influence their decisions.
The report identifies elements that play on the psyche of the investor and have a direct impact on his decisions, the most important of which are the following:
- Greed.
- fear
- Exaggerated self-esteem.
- Considering the human element in decision making.
- The time effect is the outcome type (winner or loser).
- Personal beliefs and their influence on decision making.
According to the traditional economic theory, individuals seek the choices that will achieve the maximum benefit in their business, but in reality we see something unrelated to this theory, because the psychological state of the individual affects him. Sometimes take decisions that are not beneficial to him.
According to the site, one of the most often irrational investment areas is portfolio investments. Individuals make many decisions as a result of their influence on sudden downturns or booms in financial markets. The Wall Street Crash of 1929 and the “Black Monday” of 1987 and their attendant crises are examples of psychological investing.
The report pointed out that the notion that individuals make rational decisions according to traditional economic theory is untrue, instead, people face different situations and events that affect their psychological state and thus the decision-making process.
In another report, the “Yaterm Creedy” website was reviewed (YathirimkritiThe most important psychological factors influencing investment decisions. This report attempted to answer the following question, Why do people make irrational investment decisions?
This question represents an important part of the study of the concept of psychological investment. The report proposed several hypotheses to determine the reasons why individuals are unable to make rational decisions:
- Probability theory.
- The effect of overconfidence.
- Herd policy.
- Backward bias.
Probability theory
The foundation of this theory was laid by Daniel Kahneman and Amos Tversky in a study published in 1979 entitled “Probability Theory: Decision Analysis at Risk.” The basic idea of this theory is that people don’t always act rationally when making decisions in risky situations, so they don’t make choices that provide maximum benefits. Losses affect investors more emotionally than gains and have a deeper impact.
The effect of overconfidence
The report defines overconfidence as an emotional state in which an individual believes that he or she possesses skills, knowledge, or advantages that are relatively superior to those of the general population. This feeling makes the individual fully convinced of the knowledge and character he possesses and the correctness of the actions he has taken or will take later, whether in his workplace, social life or investing. This type of people tend to make sudden decisions, ignoring the possibility of something going wrong, which increases investment risks.
Herd policy
It is defined as individuals who follow a certain behavior and way of thinking because “everyone else does.” When a particular behavior or belief is adopted by a large group, it increases the likelihood that someone else will adopt that behavior or belief. Psychologists point out that this effect negatively affects people’s thoughts and decisions.
How does the herd effect occur?
Charles Mackay, author of Extraordinary Popular Delusions and Madness of the Masses, published in 1841, reported that people think collectively while reasoning individually and slowly. People are easily influenced by society’s norms and ways of thinking, so if the majority accepts a certain behavior, it is very difficult for an individual to reject it. The resulting pressure affects people’s thinking, lifestyle and even their political thinking.
People do not want to be alone, they want to be on the winning side, and they believe that this can be achieved by accepting the opinions of the majority. At the same time, their need for a sense of self makes them accept the norms and ethics recognized by the majority.
Backward bias
It’s the scientific equivalent of the phrase that often echoes in our daily lives, “It was obvious it was going to happen.”
People encounter events and phenomena on a daily basis in their social lives, at work and when making investment decisions.
When faced with these events, people experience many emotions such as happiness, fear, sadness and jealousy, especially when they are under extreme stress or unable to make decisions.
When conducting large-scale transactions in the stock market – for example – if the financial source for this investment is debt, a person can suffer from such an emotional state, and this can lead to many wrong decisions. A sense of hindsight, thus causing him to lose his financial portfolio.
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