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Investment psychology, in a nutshell, is the process by which an investor watches established levels of value in the market to make decisions for future investments. In other words, it is how investors think when considering whether to buy or sell stocks, or invest in any other way.
Investment psychology has been well-studied and there is an extensive amount of information available on the topic; however, to get a basic grasp of the concept, here are some of its main theories:
Contrarian Theory – This theory takes a look at why it seems people buy or sell stocks in contrast to how consumers spend their money. Consumers seem to buy when prices are low, while a common investorbehaviour is to buy when prices are high. It also notes that some people playing the stock market simply follow the crowd to avoid making embarrassing mistakes alone.
Prospect Theory – This theory suggests that people will respond differently to the exact same situation depending on whether it is presented to them as a loss or a gain. Inside this theory is ‘loss aversion,’ which means that people are willing to take more risks if they feel it will help them avoid losses, but won’t do it as much to realize gains.
Regret Theory – This looks at the emotional reaction people have after making an error in judgement. This applies to having bought a stock that has now gone down, not buying one that went up, or selling at inopportune times.
Anchoring – This is an investor behaviour inherent in those who assume current prices are the correct prices because they lack better information. In this phenomenon, people give a recent experience too much credit, when in actuality, it may not occur again any time soon.
Market Over- or Under-Reaction – This is the market-wide consequence of investors relying too heavily on what they find in the news. As a result of the good or bad news they've learned, they may become too optimistic or pessimistic – and the prices in turn rise too high or fall too low, leading to extreme events like manias and crashes.
As many experts have discovered, playing the stock market not only involves the simple desire to buy or sell stocks; it also comes with it a whole world of investment psychology. But it’s not a bad thing because learning more about why people invest the way they do can help to better understand the unpredictability of the market and what it will likely do next.