Understanding the psychology of investors

Sum analyzes how investor's portfolios are affected by their emotions and biases. 

Emotions determine tolerance for risk and tolerance and risk plays a key role in portfolio selection. Investors experience a variety of emotions as they, ponder their alternatives, make decisions about how much risk to bear, ride the financial roller coaster while watching their decisions play out, assess whether to keep to the initial strategy or alter it, ultimately learn the degree to which they have achieved their financial goals. According to folklore, greed and fear drive financial markets, but this is partly true, while fear does play a role, most investors react less to greed and more to hope.

There is another way to consider this phenomenon on an emotional time line in which time advances from left to right. Let’s assume Investment decisions are at the left and goals at the right. Investors experience a lot of emotions as they move on an emotional time line from left to right and wait in the middle. Hope and fear are polar opposites on the time line, one positive, and one negative. Positive emotion is above the time line and negative below. As we move from left to right, hope becomes anticipation and then turns to pride. Fear become anxiety and turns to regret.

Investors form portfolios using a layered pyramid. Pyramid is structured to address the needs associated with security, potential and aspiration. At the bottom of the pyramid are securities designed to provide investors with security. As we move up the pyramid securities designed to address the needs for potential growth and fulfillment of aspirations are added. Investors think in term of layers, bottom layer for security and top layer for potential. They are willing to take fair amount of risk on the upside, once they have adequate protection on the downside. Most investors do not choose securities by ascertaining where the risk return profiles place the securities on the mean variance frontier, rather investor choices stem from their emotional reaction to the features promised by the securities. Those that promise safety appeal to investors who primary reaction is fear. Securities that promise safety appeal to investors whose primary emotion is hope. Many investors are driven by both emotions – we can categorize them as cautiously hopeful (I fall in this category).

Having a financial advisor enables the investor to carry a psychological call option. If an investment decision turns out well, the investor can take the credit attributing the favorable outcome to his or her own skill; however if the decision turns out badly, the investor can protect his or her ego and lower the regret by blaming the advisor. The phenomenon involves self attribution bias. 

While forming pyramids and using layered investing, anticipation adds a lot of value to investing decisions. Anticipation is the manifestation of hope and anxiety of fear. Tolerance of risk is thus a function of hope, fear and aspirations. When a major financial goals is within reach, fear and aspiration combine to favor a conservative approach. Individual investors are especially prone to heuristic driven bias. Investors are excessively optimistic about the performance of shares they own but not the market index. They are overconfident and they are often surprised by the prices changes to their stock more frequently than they had anticipated. Their stock price forecasts are anchored on past performance ad they underestimate the degree to which their stocks move in tandem with the market. 

Attribution: Key inputs for this blogpost taken from CFA Readings.