What is Investor Psychology?
Investor Psychology refers to the study of emotional and mental influences on the investor’s decision-making process.
Understanding your own investor psychology is an essential element of the trading journey, as both profits and losses leave an impact on the investor’s behavior.
Investor behaviors and biases
“Cognitive dissonance,” is a phenomenon known characterized by the discomfort caused by contradictory evidence. Investors often encounter difficulty in adjusting their perspectives, particularly when they have invested significant amounts of time, energy, and resources into a specific market. As a result, traders tend to gravitate towards information that aligns with their existing viewpoint, shaping their trading decisions based on anticipated outcomes.
“Positive feedback loops” present within financial markets can give rise to self-amplifying and inherently unstable dynamics, resulting in the creation of extreme market highs and lows. This phenomenon occurs when increased investments in a particular stock drive up both its demand and price, thereby attracting even more investors. However, as liquidity eventually diminishes, the upward momentum of prices comes to a halt, leading traders to initiate withdrawals and potentially establishing a new market bottom.
“Breakout and Failure” is a behavior led by the assumption that the price will continue in the same direction. However, it is common to experience a throwback to the breakout level.
The tendency of people to be less willing to take risks with their profits, known as “Prospect Bias”, as well and “Certainty Bias” the preference to secure a small profit rather than risk it for a potentially larger gain are phenomena attributed to this behavior.
“Trend Persistence” is a phenomenon usually led by ego or a “no regrets” attitude.
Check the below graphic representation, traders who bought at point 2 often increase their buying activity when the price retraces and finds support at point 3. This approach is driven by the desire to validate their initial decision and prove that they made the right choice.
When trades start to accumulate losses, traders often face dissonance. With the belief that prices will eventually rebound, they end up buying more (averaging down), in an attempt of avoiding losses. This behavior can be attributed to “Sunk Cost Bias”, which reflects an unwillingness to accept and confront losses.
“Pullbacks” (as a second chance)
Following the same graphic representation, during a pullback at level 3, traders who missed the opportunity to act at point 1, may experience Regret, prompting them to take a long position.
Meanwhile, another group of traders who initially went long at point X but sold at point 1 may regret their decision and seek re-entry opportunities. This interplay of “Regret Bias” and “Prospect Bias” showcases why uptrends display higher peaks and troughs. Furthermore, it clarifies the transformation of resistance levels into support levels and vice versa.
As a result of behavioral phenomena, we have “Price Barriers” and “Chart Patterns”.
When prices approach a barrier, they encounter opposing forces that cause them to reverse direction. This behavior explains the existence of support and resistance levels and is called “Trent Inhibiting”.
Similarly, due to this learned behavior, chart patterns emerge, such as triangles and channels. Professional traders may exploit this knowledge by orchestrating false breakouts to capitalize on market participant’s reactions.
Various trend-related price phenomena, such as breakouts, pullbacks and re-tests, can be attributed to different explanations.
Understanding cognitive biases and emotional factors is vital for traders and investors to make informed decisions and steer clear of common pitfalls.
Key strategies like diversification, long-term investment outlook, using professional financial advisors, and enhancing financial literacy can help navigate investor psychology and increase chances for financial success. Financial Advisors can help manage emotion biases, providing objective advice, assessing risk tolerance, and monitoring portfolio performance.
Main Group FX offers valuable assistance in navigating investor psychology and increasing the likelihood of financial success.
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