Understanding the psychology of investing goes a long way in explaining markets behavior. Investor psychology explains irrational behavior that leads to market volatility, crashes and manias.
Much of economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process. However, researchers have uncovered a surprisingly large amount of evidence that this is frequently not the case! There are numerous examples of irrational behavior and repeated errors in judgment.
Human beings are influenced by one another and we all consciously or unconsciously subject to fashion trends. Fashion determines how people behave. This explains why people had short hair in the 1950s but long hair in 1970s, and why bomb shelters were in hot demand in the 1960s but had fallen of the radar in the 1980s although the amount of thermal nuclear weapons had grown exponentially. It also explains why political liberalism and conservatism swings back and forth in popularity like a pendulum. We are influenced by the people around us. This is just as true for investing as it is true for every other fashion trend.
You can find evidence of fashion trends in investing anywhere from the bubble in Japanese stocks during the late 1980, in the gold mania in the US in the late 1970s, in the tech stock frenzy in the US in the late 1990s, and in the real estate mania in the mid 2000s.
It is in our human nature to share information with each other and influence each other. This is true in science, finance, and economics. We share our feelings with our friends, coworkers, and significant others and build relationships. This is a good thing except when it comes to investing. Sharing of information leads to fashion trends. People emulate each other and this leads to fashion trends which cause an increase of funds to flow to a particular asset in demand. Just like it was popular to own popular to own tech stocks in 1999 and buy real estate in 2005.
Every asset class rise and fall in popularity just like the latest hit on the radio. The problem with popular investments is that they are expensive. Prices of popular investments are high because everybody already owns them, which means that there is little upside potential. For an investment to increase in price there has to be a new pool of buyers available with fresh cash ready to inject.
As a result popular investments are usually more risky. There is always the possibility that more suckers will buy at even higher prices and make an expensive investment even more expensive. But once an investment is popular its upside potential is limited but the downside is huge.
For this reason it is better to adapt a contrarian mindset and stay away from popular investments. Savvy investors buys assets before they become popular and sell once they have become popular.
Here are a couple of strategies you can use to make sure you dont get caught up destructive investing psychology.
1. Adopt a contrarian mindset
Look at conventional wisdom and dont assume that it is correct. If the majority of people say that stocks is the best investment in the long run that probably means that the majority of people already own stocks and the market is fully priced. Look for investment opportunities elsewhere with strong fundamentals that not yet are favored by the majority.
2. Great company equals great stock illusion.
It has become conventional wisdom that a great company must be a great stock but looking at past result this is simply not true. Great companies often have had great investment return but once the company has come to fame it is already fully priced and returns onwards tends to be average.
3. Think for yourself and do your own research.
We are influenced by other around us and they affect our behavior. Be critical and check facts for yourself. Dont rely on your friends or the expert on television to tell you what to buy. In fact if you see a lot of people advocating it a particular investment it is probably wrong.