Five ways to use the psychology of investing to profit

One skill that separates good investors from bad investors – and great investors from those who are merely good – is the ability to understand the role that psychology plays in investing. With markets at least partially driven by fear and greed, being aware of your own flaws and controlling your emotions can help you avoid bad investment decisions. What’s more, recognising the same flaws in others can also help alert you to the investment opportunities created by market irrationality. Here are five tips to help you win the “inner game” of investing.

1. Be patient

Financial markets have a tendency to change their mind frequently in the short run. Sometimes this is justified by genuine changes in events, such as the Wall Street Crash of 1929. In other cases it is a reflection of genuine uncertainty, like the rapid fall and rise of global stockmarkets during the first few months of 2020 as people struggled to grasp the extent of the Covid-19 pandemic, and how governments and central banks would respond. But other market moves, such as the dotcom bubble at the start of 2000, were clearly influenced by changing sentiment among investors.

All this creates a lot of additional volatility. Indeed, Robert Shiller of Yale University won the Nobel Prize in 2013 for his work showing that, historically, stock prices have been much more volatile than you’d expect compared with the much lower volatility of future earnings and dividends of the underlying companies. As a result, those who have a large amount of money in shares, either in individual companies or even in the market as a whole, need to be prepared to put up with a lot of short-term volatility (which is why it is a bad idea to invest with borrowed money).

The good news is that over the medium to long term the stockmarket tends to bounce back from even the worst performances quite quickly. When you take into account the superior long-term returns of shares over most other assets, you are almost guaranteed to end up ahead over any substantial period – provided that you have the discipline not to panic and sell all your investments at the first sign of trouble. The best way to avoid this is to stick to an investment plan, such as regularly putting a fixed amount of your income into an index fund that follows the market, or maybe a couple of diversified investment trusts.

2. Don’t chase your losses

Patiently feeding consistent amounts into the market as a whole is one thing. But when it comes to individual shares, it’s a bad idea blindly to double down on losing investments, as all the evidence suggests markets tend to have a lot of short-run momentum. Indeed, Elroy Dimson, Paul Marsh and Mike Staunton of London Business School have found that a portfolio consisting of the shares that had done the best over the last six months would have beaten the wider market from 1900 to the end of 2020 in most developed country markets.

This short-run momentum is why a lot of professional short-term traders live by the saying “cut your losses and let your winners run”. Many also use stop-losses, which automatically sell a share if it falls below a certain amount. While stop-losses are for traders, putting more money into individual shares that have done badly just because they have fallen can leave you with painful paper losses, causing you to panic. Doubling down on a bad investment is also bad from a risk-management perspective, as it can lead to an unbalanced portfolio, with too much of your money in one single position.

As well as resisting the urge to buy more of a losing share, should the individual shares that you buy fall by 20%-25%, it’s always a good idea to reflect carefully on whether the reason that you bought them still makes sense and remains applicable. If either the fundamentals have changed, or the original reason doesn’t seem as sensible as it did at first, then you should sell them. Doing this can help you avoid holding onto a position that has been doing badly for too long, out of an unwillingness to admit defeat and take a loss.

3. Ignore rumours

Despite the investment saying “buy the rumour and sell the news”, basing your investment decision on rumours can be a bad idea. The most obvious problem is that a lot of them usually turn out to be false, especially since it is against the law for people with privileged access, such as company directors, to take advantage of this inside information or to encourage others to do so. Insiders may also have their own agendas in spreading rumours, such as trying to prop up the share price of company.

Rumours from people without any direct knowledge, or only second-hand information, are little better, as they may end up being misinformed or based on false information. Bernard Baruch, the famous investor, financier and adviser to several American presidents, once recounted the story of a relative who overhead him on the phone talking about a company, and immediately went out and bought shares in it. It was only after she had lost a lot of money in the trade, and confronted him, that it turned out that, far from talking about investing in it, Baruch was in fact discussing betting against it.

Ironically, while the market tends to overvalue rumours, there is some evidence that the market also tends to undervalue hard news. A 2006 study by Russell Lundholm of the University of Michigan, Jeffrey Doyle of Utah State University and Mark Soliman of Stanford University found that between 1988 and 2000 you could have produced large excess returns by buying shares in companies that had experienced big positive earnings surprises. These excess returns persisted for over two years. By contrast, shares that had negative earnings announcements tended to lag the market.

4. Avoid the hype

Rumours aren’t the only thing that can lead you into bad investments. Simply copying what your friends, family and the media as a whole are doing can also cause problems. One reason for this is that people who are copying others tend to be slow to react, so by the time that they become interested in a company or sector the opportunity has already gone. What’s more, the fact that they have suddenly become interested in finance is itself often a signal that people have become irrationally optimistic, which also leads to inflated valuations followed by a subsequent collapse.

This pattern of boom-bust has been codified by the research and consulting firm Gartner in its hype cycle, originally developed for technology, but which can be applied to other types of investment. The first stage of the hype cycle is the “innovation trigger”, when a new technology (or idea) is discovered. Initially only scientists, entrepreneurs and specialist investors are interested. This leads to the “peak of inflated expectations”, where investors start pumping money into the sector based on unrealistic projections about future rewards and a fear of being left behind. In the third stage, prices collapse as people dump their shares.

The best way to avoid this trap is either to invest at an early stage, where valuations are still low (although the investment opportunities may be limited), or wait until the price has collapsed. Either way, it’s generally a good idea to avoid investing in the second stage when prices are at their peak. Perhaps the best way to do this is be suspicious about shares that have high valuations, where people are making outrageous predictions of future success, or companies that are the subject of investment tips from family or friends.

5. Invest against the crowd

Just as the crowd can sometimes overvalue a share or asset, it can also undervalue it. Frequently this occurs immediately after something has been heavily hyped. Indeed, during what Gartner calls the “trough of disillusionment”, people start to panic when their unrealistic expectations are not immediately met. Investors stop putting money into the sector, companies collapse, and the value of shares of those that remain plunge. For example, not only did Amazon’s shares lose more than 90% of their value between January 2000 and September 2001, but many people also thought the firm might go bankrupt.

The good news is that such shares can make great investments if you are willing to buy when they are cheap and then hold on until things return to normal, or the technology starts to pay off (what Gartner calls the “slope of enlightenment”). The classic example of this is Amazon, which not only fully recovered from the dotcom collapse, but is also now one of the largest listed companies in the world.

Overall, if you really want to be a successful investor (as opposed to trader), you’ve got to develop a willingness to go against the market, by finding cases where market sentiment about an asset is at extreme levels, and then going in the other direction. While contrarian investing is sometimes seen as a synonym for being bearish (or pessimistic) about a share or asset, proper contrarian investors are willing to be bullish as well as bearish, snapping up shares that are shunned by the rest of the market (and selling them when they become too popular). Indeed, the very best are flexible enough to go against the market when it hits one extreme, and then reverse direction when it swings too far the other way.

• Investing Explained: The Accessible Guide to Building an Investment Portfolio by Matthew Partridge is available now from Kogan Page (£16.99).