Stock Market Psychology: How to Think on the Stock Market
Does the saying seem familiar to you?
All head thing.
He is as unremarkable as he is on the stock market. Stock market psychology is perhaps the most underrated discipline in finance, and yet, in my opinion, it is the most important. Because only with the right mindset and knowledge about you and your innate weaknesses, you can have long-term success with stocks.
- What is the Prospect Theory in Exchange Psychology?
- Why you should not care, whether you make profit or loss
- What I do
- Why it’s good to be average on the stock market
- Immediate Tip: Avoid News!
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What is the Prospect Theory in Exchange Psychology?
Let’s do a little experiment:
- You have 50,000 € and invest the money in a portfolio. You were incredibly lucky and after three months you made a big profit of € 40,000. Therefore, you stand at a total of 90,000 €. However, you are unsure what you should do best now, because many analysts believe the market will remain very volatile. Should you sell now or stay invested? How do you decide?
- Just like before, you have 50,000 € and invest in exactly the same portfolio. Only this time you have really unbelievable bad luck and lost 40.000 € in only 3 months. This leaves only $ 10,000 left over from your original assets and experts say the market will continue to be very volatile. Should you sell now or go all out and stay invested because the market is sure to recover? How do you decide?
How did you decide in each situation? If, in the first scenario, you choose to take your profits and go all-out and invest in the second scenario, you’re in the majority of investors.
The problem here is this is not rational.
It only makes sense to behave the same way in both situations, because logically, there is no difference between the two cases. However, humans tend to rate gains mentally differently than losses.
That’s in our nature. If we gain something, then we are immediately afraid it could be taken away from us (call evil tongues something like that also become adults) whereas we have the hope to make up for our losses somehow, if we lose something.
In other words, we are risk-averse when we are in the plus and are willing to take risks if there is a loss. However, as I said, this is not logically consistent, because you should actually stick to your risk attitude regardless of book profits / losses.
It is also empirically proven that investors realize profits rather than losses. Simple and simple, because humans evaluate them emotionally differently. To act rationally should not make any difference to you if you have just made a profit or a loss, your decision must always be consistent.
In stock market psychology, this phenomenon is explained by Prospect Theory , so to speak about expectation theory. They discovered the psychologists Kahneman and Tversky, for which there was also the Nobel Prize. I would like to mention here that above is a reduced example without probabilities of this theory.
Conclusion 1: Only investors who act rationally will succeed in the long run.
Why you should not care, whether you make profit or loss
So now we know that we should not let emotion guide us and make our decisions consistently. So what should we do? The answer is simple:
That’s right, nothing. If you have a broad and well diversified portfolio then it does not matter if you made a profit or a loss, the best you can do is nothing. Terribly comfortable right?
Let me explain this: Basically, all this profit-taking and loss-limiting is nothing but market-timing. And you should not time the market (11th bid), because that will bring you nothing in the long run. Incidentally, the commandment is not mine, but comes from scientific investigations. And since you can not see any advantage by timing tests.
Conclusion 2: Markettiming is useless and most likely results in an underperfomance. No marketing.
That means we know thanks to stock market psychology and science that we must behave consistently and not time the market. So what should we do?
What I do
With what I know about the stock market and the economy, I’ve hammered out a simple plan:
Over a period of 20-30 years, I invest a fixed monthly amount in a portfolio that reflects the state of the art. So the usual: Diversification, low cost, market wide, and so on. In this portfolio is stubbornly paid whether it storms on the stock market or the sun is shining. This is done ice cold, year after year. And in the past that was the plan that always worked. This is from the stock exchange psychological point of view already an advantage, because it calms one despite questionable explanatory power. That’s the way man is built.
For longer investment periods, the average cost effect (cost average) continues to be used with a constant, regular investment amount. This means nothing else than buying stubborn regular buying when prices are high and when prices are down.
On average, you have then achieved a price somewhere in between. The nice thing about this is that you automatically buy fewer shares at a constant amount at high prices and more automatically at low prices. For cost averaging I will again write a detailed extra article. If you sign up for the newsletter, you will automatically receive an e-mail.