Psychology of finance: How to use psychology to improve your gains

Psychology and finances are two completely different fields at the first glance but if you take a closer look you will see that they have quite a lot in common and linking this integrating these two disciplines is actually can be something worthwhile for making the right decisions, improving gains and reducing losses. Researchers have been studying the role of psychology in finances for years now and they found out that applying psychology to finance can be something useful for investors. There is a new discipline about integrating psychology into finances and it’s called Behavioral Finance.

What is Behavioral Finance?

It’s a subfield of behavioral economics, as well as psychology which studies how cognitive biases and psychological influences affect the thinking patterns of investors and changes the way they act. These kinds of influences play a major role in explaining market anomalies and especially, in estimating severe rises and falls in the stock market. All the principles of this field make us believe that when it comes to investments, we can be the worst enemies of ourselves. The field was first introduced in 1979 by Daniel Kahneman, a Nobel Prize winner and a well-known American psychologist and economist with the help of psychologist Amos Tversky.

Behavioral Finance often confronts traditional finances according to which investors are quite rational. The theory is called the Efficient Market Hypothesis(EMH) and as it suggests, investors are the ones who make decisions without involving any emotions at all, which is a bit of fantasy as there is no human being who’s decisions aren’t affected by their emotions, cognitive processes and their psychology in general.

Investors often experience variable emotional states and they can go from extreme optimism to sudden panic or depression during risky times. Studies show that mood swings are quite common with them, as rapid phases of market acceleration or deceleration make their emotional state go constantly up and down. Therefore, knowing how their mental states influence the way they act can help them seek investment objectives more effectively. However, EMH supporters believe that investors usually carefully analyze all the alternatives around them and make their investment decisions only after considering every possible decision. Opposing to this, Behavioral Finance believes that thor decisions are based on bounded rationality meaning that they focus on the more satisfactory outcomes and process information until they get what they want but not what is the best and what they need.

Influences on investor’s decision making

It’s a commonly known fact that the human thinking process is full of different biases. Almost none of our decisions are made completely rationally as the decision-making process itself involves various flows as we never use the whole potential of our cognitive resources. Making errors is a usual part of processing information which often leads to false conclusions.

One of the most common cognitive biases is Confirmation Bias which often has a crucial effect on investors’ decisions. It means that when we receive some information that supports our conclusion, we tend to accept it without even checking alternate decisions and thinking deeply. For example, I may believe that I should buy eBay stock, and now is the perfect time for doing so. At that moment if I read a study advising buying eBay stock, this "evidence" will be enough to make a decision immediately, go ahead and buy it, even though there may be lots of other reports which state the exact opposite.

Another important bias, which plays a key role in investors’ decisions is called Self-Control Bias. It’s a tendency to spend more money today to save it later but actually, investors who use this strategy often can’t control their spending. They just gain short-term benefits but they may experience a great loss in the long-term.

Also, paying attention to the Familiarity Bias is something important while making decisions about investments. It’s a term referring to the fact when investors tend to invest in what they are familiar with, like local companies, and as a result, the risk is higher because they are not diversified across multiple types of investments.

Besides these cognitive biases, several factors can impact on the way investors make decisions and there are tons of research proving the many flaws in their decision-making. For example, according to Forbes, if you need to have a relatively fearless financial life, you have to consider three things: your emotions play a huge role in making decisions, anxiety, and avoidance can be harmful factors as well, and lastly, you can’t entirely escape the history of your family’s mental issues and your past.

Can we avoid cognitive biases?

Yes! Avoiding making stupid decisions may be a difficult task, but it doesn’t mean it’s something unattainable. For this, you need to carefully analyze your decisions from every single perspective and before taking an actual step. For example, if you want to avoid spending problems and stay away from self-control bias you have to plan your retirement reasonably or you may set up automatic deposits every month into a savings account from your paycheck. That way, you will realize your money’s true power in the future.

So to be a reasonable investor, try to make rational decisions, be patient, and not let your emotions have such a huge impact on your performance. That way, you will save money and improve your gains.