The psychology behind every bad investment you’ve ever made

Imagine losing $50 from your wallet and feeling upset about it for the entire day, but finding $50 later and feeling happy only for a few minutes. Even though the amount is the same, the loss feels much more powerful than the gain. Why?

To understand this, we have to delve into a branch of economics known as behavioural finance. While traditional finance assumes people make the most rational decisions, behavioural finance dives deep into how cognitive biases and emotions shape our financial behavior. To put it simply, behavioural finance weaves psychology and economics together to better understand how individual investors make financial decisions.

A key concept in behavioural finance is representative bias, a cognitive bias that influences an individual to judge an event based on a mental model or stereotype, rather than on its actual probability:

1. Gambler’s fallacy/Monte Carlo fallacy: This is a mistaken belief that if a random event occurs more frequently than expected in the past, it is less likely to occur in the future. For example, if a wheel keeps landing on red, the gambler will assume that the next time the wheel is spun, it will land on yellow because it's ‘due’. However, the idea is that no matter how many times the wheel lands on red, the next time it is spun, there will still be a 50-50 percent chance of it landing on either yellow or red.

2. Base Rate Neglect: When we are provided with both individuating information, which is specific to a certain person or event, and base rate information, which is objective, statistical information, we tend to ignore the base rate information. For example,  suppose you are told “Tom is a shy person” and you are asked if Tom is a librarian or a sales person. Your likely response is that Tom is a librarian due to a stereotype of librarians being quiet and introverted. However, this judgement overlooks the base rate—the actual proportion of librarians versus sales people in the population. If there are more sales people in the population, then it is more likely that Tom is a sales person, even if he is shy.

3. Availability bias: This is when people overestimate the likelihood of an event because of how easily it comes to the mind. This is usually fuelled by 24/7 media coverage. A classic example is how people are more scared of rarer risks like terrorism and plane crashes compared to much more common risks like car crashes. This is probably because of how publicised terrorism attacks and plane crashes are in comparison to car crashes which are in fact more dangerous to the individual’s life.

Below are other biases that affect people’s financial decisions-

1. Confirmation bias: I’ll be real. I have selective hearing, a phenomenon where you hear what you want to hear. Confirmation bias is similar to this. This is when investors choose to listen to facts and data that match their belief and ignore those that go against it. For example, If you’re working on a school project regarding how AI is destroying students’ creativity, then you will try to find facts that support your stance rather than ones that indicate that AI can act as a catalyst for their imagination. 

2. Herd mentality: No, I’m not talking about some type of gangster mentality, though the idea may be similar. Let me put this in very simple words, herd mentality is to follow the group. It's when investors follow other investors while making a decision rather than relying on their own analysis. This can often drive speculation by causing prices to rise beyond what it’s actually worth. The dot-com bubble in the late 1990s is a perfect example: During this time, investors rushed to invest in any internet-related company to avoid missing out (‘FOMO’), ignoring traditional metrics like earnings and revenue. This eventually resulted in a massive stock market crash.

3. Loss aversion: At the start of this article, I gave an example. Loss aversion explains that example. The key idea here is that losses hit harder than gains, so even if you’ve made some amount of profit, if you’ve experienced a bit of loss, you will tend to immediately withdraw yourself from that investment. This is one of the reasons why people miss out on great opportunities. For example, let's say you’re an investor new to the market. You‘ve invested in a stock, but just a few days later, the stock price of that company starts to decrease. You become worried and so you sell your stock like others do. However, if you were a bit more patient, you would have earned profits by letting the stock price gradually increase after some time. Your fear of experiencing a loss caused you to act impulsively and irrationally, making you lose out on a greater amount of profit.

4. Familiarity bias: This is when investors refrain themselves from experimenting. Some investors choose not to invest in certain stocks, because they have never done so. They prefer sticking to ones that they are familiar with. This hinders their ability to diversify their portfolio and exposes them to more risk.

In conclusion, in the real world, investors don't necessarily make the most rational decisions because of various cognitive and emotional biases. Human behaviour is strange and it’s important that we understand how it affects their decisions because….don’t you want to be a millionaire?