Notes on Investor Psychology, Risk Assessment, and Self-fulfilling Prophecies

Sun, Nov 8, 2020 6:22 AM on Stock Market, Exclusive, Recommended,

Investing in the stock market is simple. If one chooses to buy a stock without any research, the stock will either go up or down.

Thus, even if you bring a completely ignorant person into the stock market, his odds of winning are 50%. This is because stocks can either go up, down, or sideways. One will either make money, lose money, or will get out even.

However, if an investor wishes to consistently generate profitable investment and fewer losing trades, he must learn to keep the odds in his favor. He should learn something that gives him an edge in the market. In other words, an investor should learn a strategy that makes him right more times than wrong. Even if he is right only 51% of the time, he has a winning strategy.

“Twenty years in this business convinces me that any normal person using the customary three percent of the brain can pick stocks just as well, if not better, than the average Wall Street expert.”
Peter Lynch

Repeating what is already implied, learning a winning edge is simple. However, the human brain does not only go up, down, or sideways. It becomes a little greedy at times. The human brain tends to gather information from everywhere, even if the source of information is unreliable. Also, fear drives the human brain like no other emotion.

As a result, the reason why most investors fail isn't because of a poor strategy. It is rather because of the fault in how he perceives market risk and returns. This tendency is piloted by his psychological state. Thus, the term investment psychology has now been a literal phrase.

Investment psychology

“Eighty percent of the market is psychology. Investors whose actions are dominated by their emotions are most likely to get into trouble”

Adam Smith, The Money Game

A lot happens at the psychological level when an individual buys a stock. Although stock market experts repeatedly howl about removing the psychological part from investing, most investors just can't do that. Humans were programmed to have emotions. That is what separates us from robots.

Thus, whenever an investor buys a stock, he incorporates his dreams and expectations into the stock. Although the stock market presents its information from a neutral standpoint, the investor will be jubilant if the stock gains. And he will feel hurt and betrayed by the market if the stock goes against him in the opposite direction.

"Don't underestimate the importance of psychology in the stock market. Many factors go into the buy or sell decision besides economic statistics or security analysis"
Roy Neuberger

Greed and fear are both common human emotions. However, these two emotions can bring a lot of trouble and pain in the stock market.

Common examples of psychological obstacles to stock market success are fear of missing out, the bandwagon effect, paralysis by analysis, and the fear of the unknown. If the reader goes through a quick google search of these terms, he will be able to better dissect everything that had been messing up with his investment plan (and hence his profits).

Risk Assessment

The discussion on market psychology is incomplete without the discussion on risk assessment.

Interestingly, a typical investor's perception of the risk in any given investing situation is a function of the outcome of his most recent two or three trades.

Investors think they accept that the stock market is a risky investment platform. However, they have no idea about when the loss will be too big and they will sell despite anything. In other words, they do not define their risk by keeping a stop-loss on their trades.

Investors don't define risk because they don't see it as necessary. They don't see it necessary because they are sure they know what will happen next. How are they sure they know what will happen next?

Because of wishful thinking. Thus, the very act of having an irrational psychological state (expectation) keeps an investor in the illusion of knowledge. This will make the inherent risk completely invisible to him.

Does all this ring a bell? Have you ever been in a state of paralysis where you can't simply sell the stock that is losing? Have you expected it to be back at your buying price so you will get out even, only to see it plunge further?

Consistently profitable investors are not excellent market predictors. Rather, they are better risk managers. And risk management is completely overshadowed by irrational investment psychology.

“Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.”
Benjamin Graham

Self-fulfilling prophecy

Some antagonists of the stock market argue that the stock market is actually a hoax. They state that all the investment philosophies work because these philosophies have been taught to the majority of investors. As a result, the investors religiously believe in the strategy because they think it works. And the strategy works because everyone believes it does and takes action in accordance with the strategy in the first place.

A self-fulfilling prophecy is a sociological term used to describe a prediction that causes itself to become true.

For instance, investors in NEPSE have seen that a bullish trend lasts roughly for five years and a bearish trend for about three years. Now, no one knows why this happens. But if enough people think that this is just the way it is, and consider it a pattern, the next move will indeed fall in their expectations.

After five years of a bullish uptrend, those who believe in this "pattern" will stop buying shares. As a result, the participation volume will decline. And if most of them also begin to unload their shares, the market will be flooded by sell orders. Now, by the law of supply and demand, the price has to decrease.

As a result, this creates a sort of domino effect. Since each move in the stock market is influenced by the move before it, the market will indeed go in a state of a self-created downtrend.

"Markets affect investor psychology, but investor psychology also affects markets" Leon Levy

Wrapping Up

This article is intended to be a passive discussion on investment psychology, investors' awareness of risk in the financial market, and a brief introduction of how the market and psychology are affected by each other in a vicious circle. This wasn't a quick how-to manual on preventing psychological interference during the implementation of an investment strategy.

Thus, we hope the reader got a simplified explanation of the topics. And about how to actually avoid being in a psychological trap in the investment world, that is a skill better learned by experience, and perhaps some incidents of portfolio loss.