Psychology and investing: Mind games


11 Jul 2022

An investor’s fears and biases could have more influence over their decisions than the fundamentals. Andrew Holt looks at why understanding psychology could make you a better investor.


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An investor’s fears and biases could have more influence over their decisions than the fundamentals. Andrew Holt looks at why understanding psychology could make you a better investor.

Asset prices are all about fundamentals. This is a clear truism of investment. Leading business schools teach this as a core and unquestioned principle, with those learned types filing out of said business schools to scurry off into the City to implement all their wise knowledge at asset manager firms.

But what if it this is a house built on sand? What if there is something else that contributes to asset pricing and market outcomes, which has little to do with fundamentals, but instead is all in the heads of investors? That is to say, it is the mind that shapes investment.

Howard Marks, author of Mastering of the Market Cycle, takes a psychological approach to investing. His contention is that the market is highly psychological, and market swings are usually created by behaviour rather than fundamental analysis.

“The most important thing they do not teach you in business school is psychology,” he says. Highlighting why this is important, he gives a potted history of investment: “If you go back and look at a graph of the [US] economy in the past 50 years, it has an upward trend and modest divergence from the trend.”

A volatile mind

Marks says that if you analyse company results over the same period, they go up and they go down, but more sharply. “If the economy is up 2%, profits go up 10%. If the economy is up 20%, profits go up 30%. And if the economy is down 2%, then for a typical company profits will be down 15%, and so forth.

“So the graph of profits is much more volatile than the graph of the economy,” he adds. “And then if you look at a graph of the stock market it is up and down. Why? What is the difference? The difference is psychology.”

And when it comes to investment, the picture becomes complicated due to this psychological factor. “People rarely do what they are supposed to do,” he says. “Often they react in the extreme to events that develop. And that extreme reaction causes extreme volatility. Sometimes they do not overact at all, and sometimes they do not react as they should.”

Marks’ view, a bit like his political namesake, appears quite revolutionary. His observations suggest a need for investors to understand markets from a psychological perspective.

He goes further, citing physicist Richard Feynman. “Physics would be much harder if electrons had feelings.”

Marks adds that people have feelings and people rarely do what they are supposed to do. “They often react in the extreme to the events that develop and those extreme reactions cause this extreme volatility.”

Taking a short cut

Therefore, the human dimension is, inevitably, always shaping the face of investment.

Putting intellectual meat on the bones of this, Paul Craven, a behavioural economist, says: “There is a form of economic thinking that says we are all rational, logical, analytical, datadriven and evidence-based. What behavioural science suggests is that we make decisions for lots of other reasons. We make mental short cuts, what is known by psychologists as heuristics. I like to think of them as having biases.”

And such biases in investment are key. “When everyone starts to think the same way, it is dangerous. In investment terms, therefore, the biases we have are important,” Craven says. He cites an example: “The bandwagon effect in investment, or the herd instinct, is the idea you choose to follow what everyone else is doing because they must know something you don’t, or something better.

“And there is strength in numbers. And if I am wrong, I am not going to stand out. Interestingly, in markets this can lead to financial market bubbles,” he adds.

Furthermore, not only do they lead to bubbles but the herd instinct repeats itself, as the history of the stock market shows.

There is another bias Craven identifies: “Hindsight bias is something we are all guilty of: we are all experts with hindsight.”

Market psychology

Professor Richard Thaler of the University of Chicago School of Business and the economist behind the ‘nudge’ theory has also studied markets and market behaviour. He has a more sceptical view of the psychology of markets perspective. “When people talk about ‘market psychology’ they are often referring to just the unpredictable turns in market sentiment,” he says.

“It is a mistake,” Thaler adds, “to think that such factors are irrelevant, but it is also a mistake to think that you can make money trying to predict when they will change. So-called meme stocks remained high for much longer than most people expected, and short sellers were either wiped out or lost patience.

“My view is that stock prices can deviate from fundamentals – somehow defined – for long periods of time, and yet that may not create an opportunity to make a profit,” he says.

But not all investment problems are down to psychological highs and lows reflected in the market but can be down to something close to the psychology of hubris, Marks says. “Most investors cannot see the future better than anyone else. And trying to predict the future will not produce investment success.

“One of my heroes [the economist] JK Galbraith said: ‘We have two types of forecasters: one who don’t know, and the ones that don’t know they don’t know.’”

This a tad Donald Rumsfeld, in his famous known unknowns speech, but it does raise a serious point about the psychology of investing. One in which in plugging into, and exploiting, future investment trends is open to question.

“The truth is, the future is uncertain,” Marks adds. “And yet, what is investing, but employing money for the future. Most investors act as if they can see the future and they base their investment decisions on their view of the future. It is dangerous, because if it turns out they cannot, as I believe, then there is a problem.”

Supporting his perspective, Marks cites a conversation he once had with a famous friend. “Warren Buffet said to me once, ‘For a piece of information to be desirable, it has to satisfy two criteria: it has to be important and it has to be knowable.’

“The macro is extremely important: how can you not base your approach on macro? I say yes, but it is not knowable. Then basing your approach on macro is a waste of time, or worse,” Marks adds.

This is wandering into territory that questions some of the essence of investment, but it does have its foundation in a particular psychology of investing.

It also highlights something else. Euan Munro, chief executive of Newton Investment Management, warns that there needs to be a line created between speculation – which this could be viewed as – and investment.

“I have seen a comment from a crypto expert opining that it was a good thing that the froth is coming out of the crypto market. Perhaps he needs to be careful what he wishes for,” he says.

“To my mind, froth in a market is when over ambitious growth expectation for a company’s profits might need to be revised down,” Munro adds. “This results in a change in valuation, but the substance of the investment is still there. I am seriously worried that a generation will be badly burned speculating and will subsequently reject investing.”

It’s all in the mind

Another way of looking at this is in what perspective is investment not psychological. A point made by Madeleine King, co-head of global investment grade research at Legal & General Investment Management. “Everything in investment is driven by a certain amount of psychology,” King says.

“We are not a completely algorithm-driven market yet. There are a lot of human decisions being made and there are certain human biases there. If you look at things like crypto and some of the market bubbles of late, it is difficult to think of that without thinking of investor psychology. There are few things throughout history that you would look at as an asset bubble, but say, ‘at the time it was driven by fundamentals’. It is rare that happens. It is usually inflated expectations and driven by the fear of missing out, as it is of people genuinely believing this is the next big thing.”

Financial bubbles can, therefore, be nothing more than mass psychological hysteria. “There are examples during financial bubbles that markets get driven up, not so much by fundamentals but by sentiment, emotion and greed,” Craven says. “Perhaps the tech bubble of the 1990s is a good example where mostly everything that was tech based went up in price and created a bubble. And even though at the time people said these valuations were justified, up went the prices.”

Craven says his favourite example of this mania is Norris Communications which used to make electronic recording devices. “It didn’t enjoy the first wave of the tech bubble, or indeed the second wave. In 1999, the last year of the bubble, it changed its name to E Digital – and from a name change its stock price started to rise. It went from 6cents to a peak of $24. And nothing had really changed, apart from its name, which reminded people it was a tech company. It’s not trading today.”

One way to avoid all this is for investors to be aware of their biases. “Just being aware of our biases is extremely helpful, it takes the sting out of the tail,” Craven says.

Identify stocks

There can be opportunities in considering the psychological aspect of investment. Professor Thaler’s expertise has meant he has put his money where his brain is, exploiting the psychology of investment in a specific way.

“At the firm I helped found, Fuller & Thaler Asset Management in San Mateo, we use behavioural finance to invest primarily in small and mid-cap US equities. We try to identify stocks for which investors and analysts have biased expectations. We invest in small cap because we think that part of the market is less efficient,” he says.

Though some market psychology investment approaches do present some bizarre ideas. One is that putting a focus on a winning mentality at all times in all circumstances will ensure investors beat the market. That would be no use in the current environment.

This presents a serious challenge to the broader psychology of investment approach within the current dire macro-economic outlook, with challenges on numerous fronts: rising inflation and the strong prospect of a recession are clearly not all in the mind.

These challenges are as real as they come. And they are the fundamentals. They may have been measured or assessed incorrectly, but, ultimately, the fundamentals have done their job.

So what can we make of markets and psychology in this current context?

Thaler says: “Times like this, with high volatility and lots of uncertainty can, in principle, be good times to be disciplined investors with active strategies. If you have a sound investing process, these are ideal times. Certainly, stocks and bonds are cheaper than they were at the beginning of the year, so it is a good time to be investing.”

This is, therefore, stepping into a traditional strategy approach: of having a suitable investment that works. What advice could the likes of Professor Thaler give institutional investors when addressing the psychology of it all?

“Have a strategy that appears to work over long periods of time and then attract clients that have patience. Investors, retail and institutional, often fire managers just as their returns are about to go up,” he says.

That could well be read as a wide-ranging warning: be aware of the psychology of investment, but do not ignore the fundamentals and certainly do not forget about the wider strategy of investment.


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