The Most Important Thing in Investing: Seven Psychological Factors That Affect Investment

Red and Green Guide: Many people may arrive at similar cognitive conclusions through analysis, but due to the varying psychological influences they experience, the actions they take based on these conclusions differ. The biggest investment mistakes do not stem from informational or analytical factors but from psychological ones.

Source: The Most Important Thing in Investing

Why do mistakes occur? Because investing is a human behavior, and humans are governed by psychology and emotions. Many possess the intellect to analyze data, but few can see things more profoundly and withstand significant psychological impacts. In other words, many may reach similar cognitive conclusions through analysis, but due to differing psychological influences, their actions based on these conclusions vary. The biggest investment errors arise not from information or analysis but from psychology. Investment psychology encompasses many independent factors, which this chapter will explore one by one. The key takeaway is that these factors often lead to poor decisions. Most fall under the category of "human nature."

The Seven Psychological Factors Affecting Investments

The first emotion that erodes investor success is the desire for money, especially when it morphs into greed.

Most people invest to make money. (Some view investing as an intellectual exercise or a way to demonstrate competitiveness, but for them, money is still the measure of success. Money itself may not be everyone's goal, but it is the unit of wealth measurement. Those indifferent to money usually don’t invest.) There’s nothing wrong with striving to earn money. In fact, the desire for profit is one of the most critical drivers of markets and the broader economy. The danger arises when desire turns into greed. Webster’s Dictionary defines greed as "an excessive or insatiable, often reprehensible, desire for wealth or profit."

Greed is an incredibly powerful force—strong enough to override common sense, risk aversion, caution, logic, painful memories of past lessons, resolve, fear, and all other elements that might steer investors away from trouble. Conversely, greed often drives investors to join profit-chasing crowds, ultimately paying the price.

Combined with optimism, greed leads investors to repeatedly pursue low-risk, high-reward strategies, buy hot stocks at high prices, and hold onto them with unrealistic expectations of further appreciation. Only later do they realize the problem: expectations were unrealistic, and risks were ignored. (Turning Hindsight into Foresight, October 17, 2005)

The second factor influencing investments is fear.

Opposite to greed is fear—the second psychological factor we must consider. In investing, this term doesn’t denote rational, sensible risk aversion. Instead, like greed, it implies excess. Thus, fear resembles panic—an excessive worry that prevents investors from taking the positive actions they should.

The third factor is the tendency to abandon logic, history, and norms. At many points in my career, I’ve been amazed at how easily people suspend disbelief.

This tendency makes people willing to accept dubious advice promising wealth—as long as it sounds plausible. As Charlie Munger once quoted Demosthenes: "Nothing is easier than self-deceit. For what each man wishes, that he also believes." The belief that fundamental constraints no longer matter—that fair value is irrelevant—lies at the heart of every bubble and subsequent crash.

But investing is a serious endeavor, not a joke. We must remain vigilant against what doesn’t work in reality. In short, investing requires ample skepticism... A lack of skepticism leads to losses. In post-mortems of financial disasters, two phrases recur: "Too good to be true" and "What were they thinking?"

What fuels such delusions? Usually, it’s greed that leads people to dismiss or ignore past lessons. As John Kenneth Galbraith put it, "extreme brevity of the financial memory" prevents market participants from recognizing the recurrence and inevitability of these patterns.

When markets, individuals, or an investment technique deliver short-term outsized returns, they often attract excessive (blind) admiration. I call such high-return methods "silver bullets."

Investors are always searching for silver bullets—calling them holy grails or free lunches. Everyone wants a ticket to risk-free wealth. Few question whether it exists or why they deserve it. Regardless, hope springs eternal.

Yet silver bullets don’t exist. No strategy delivers high returns without risk. No one has all the answers; we’re only human. Markets evolve, and like many things, the window for windfall profits diminishes over time. Belief in silver bullets leads to ruin. (A Realist’s Creed, May 31, 2002)

The fourth psychological error is herd behavior (even when the consensus is obviously absurd) rather than standing firm.

In How Markets Fail, John Cassidy describes Solomon Asch’s classic psychology experiments from the 1950s. Asch asked test groups to judge what they saw, but only one person in each group was the actual subject—the rest were plants. Cassidy explains: "This setup placed the real subject in a dilemma: as Asch put it, ‘We subjected him to two opposing forces: his own perceptions and the unanimous opinion of the group.’"

A high percentage of real subjects ignored their own observations to conform with the group, even when the group was clearly wrong. This experiment demonstrates the power of the crowd, reminding us to take consensus with a grain of salt.

"Like Solomon Asch’s subjects in the 1950s," Cassidy writes, "many who dissent from market consensus feel ostracized. In the end, the truly crazy ones are those who don’t understand the market."

Time and again, the pressure to conform and the desire for profits lead people to abandon independence and skepticism, casting aside innate risk aversion to believe in nonsense. This happens so often that it must stem from inherent, not random, factors.

The fifth psychological influence is envy.

However negative greed’s force, it at least has an aspirational side. Envy’s corrosive effect is worse. This is perhaps the most harmful aspect of human nature.

Someone content in isolation may become miserable upon seeing others do better. In investing, most find it hard to watch others earn more.

I know a nonprofit whose endowment returned 16% annually from June 1994 to June 1999—yet its stakeholders were dismayed by peers’ 23% average returns. Without growth stocks, tech stocks, acquisitions, or venture capital, the fund lagged over five years. Then, as tech stocks crashed from June 2000 to June 2003, the fund’s 3% annual return (while peers lost money) delighted stakeholders.

Something’s wrong here. How can earning 16% annually be unsatisfying, while 3% brings joy? The answer is our tendency to compare—a tendency that undermines constructive, analytical investing.

The sixth key influence is ego. Remaining objective and prudent in the face of the following facts is immensely challenging.

Short-term investment performance is evaluated and compared.

In boom times (which dominate), reckless or even misguided risk-taking often yields the best returns.

The best returns bring the greatest satisfaction. When things go as hoped, feeling smart and receiving recognition is gratifying.

In contrast, thoughtful investors toil in obscurity, earning steady returns in good years and minimizing losses in bad ones. They avoid high-risk actions, keenly aware of their limitations and prone to self-reflection. To me, this is the best path to long-term wealth—but it offers little short-term ego gratification. Humility, prudence, and risk control aren’t glamorous. Of course, investing shouldn’t be about glamour—but it often is.

The seventh influence is capitulation—a behavior typical late in cycles.

Investors try to hold their convictions, but when economic and psychological pressures become overwhelming, they give in and follow the crowd.

Generally, those entering investing are intelligent, knowledgeable, worldly, and numerate. They grasp business and economic subtleties and understand complex theories. Most can reach reasonable conclusions about value and prospects.

But psychology and herd influence intervene. Most of the time, assets are overpriced and keep rising or underpriced and keep falling. Eventually, this trend undermines investors’ psychology, beliefs, and resolve. The stocks you sold keep making others money; the ones you bought keep falling. Concepts you deemed dangerous or foolish—hot IPOs, profitless tech stocks, highly leveraged mortgage derivatives—are touted daily.

As overpriced stocks perform better or underpriced ones worse, the right move grows simpler: sell the former, buy the latter. But people don’t. Self-doubt mingles with tales of others’ success, forming a potent force for poor decisions. The longer this persists, the stronger it grows. This is another force we must resist.