How emotions and beliefs affect investment decisions

Many women who start to take an interest in investing assume that a good investment decision results above all from knowing the company, the basics of the market and the ability to read data. This is an important part of the whole process, but not the only one. Even when an Elegant Investor reads a lot about a firm, checks its results and gets to know other people's opinions, she still looks at this information through her own experiences, emotions, worries and earlier beliefs. For this reason an investment decision is not only the effect of analysing numbers, but also the result of how these numbers and information are understood.

It is precisely here that cognitive biases appear, meaning ways of thinking that simplify the assessment of a situation and can lead to conclusions based only on part of the picture. The mind tries to work efficiently, so it orders information, picks out what seems familiar and looks for quick sense in what it sees. In ordinary everyday matters this often helps, because we do not analyse every detail from the beginning. In investing, however, the same mechanism can make a calm assessment of a company, the risk and your own decision harder, especially when strong emotions or a feeling of uncertainty appear.

On the stock market this is very clearly visible, because decisions concern money, and money rarely stays emotionally neutral. When a share price rises, it is easy to decide that the rise will last longer and that it is worth acting right away. When the price falls, many people start to react with tension and the wish to quickly get out of the situation, instead of returning to a calm assessment of what has actually changed in the company itself. This is why in long-term investing what matters is not only understanding the market and firms, but also noticing how your own mind interprets information and affects decisions.

What cognitive biases are

Cognitive biases are recurring ways of thinking that affect how we understand information and how we make decisions. In practice this means that the same situation may be assessed in an incomplete or too one-sided way, even though at first glance everything seems logical. The mind often chooses the fastest explanation, rests on the first impression or attaches itself to one element that seems the most important. As a result, part of the information moves to the background, although it also matters.

In investing this is especially clearly visible, because decisions are made in conditions in which the future cannot be known. No one knows in advance how a company will develop over the following years, how the market will react to new results or how the economic situation will change. When the future stays open, a person begins to look for something that will help her assess the situation faster. Sometimes this becomes one opinion read on the internet, sometimes a former share price, and sometimes one event that gains too much significance in the assessment.

This is why cognitive biases affect investment decisions when you try to understand a company, assess the risk and decide whether a given investment makes sense. The better you understand these mechanisms, the easier it is to notice when you are looking at the situation broadly, and when you are basing your assessment too strongly on one impression, one number or one emotion.

When we look for confirmation of our own opinion

One of the best-known cognitive biases is the confirmation effect. It consists in the fact that we more easily accept information consistent with what we have already considered true, and approach with greater distance that which undermines an earlier opinion.

Let us assume that an Elegant Investor considers a certain company to be very good. So she starts reading articles, watching materials on the internet and following other people's statements about it. With time she gives more attention to the content that shows the firm favourably. She remembers good news better, and weaker results, rising debt or problems in the industry she more easily considers temporary. In such a situation the analysis still goes on, but it stops covering the whole picture. This is exactly why the confirmation effect can be so misleading. An Elegant Investor may have the feeling that she is acting sensibly and checking the company thoroughly, although in practice she mainly strengthens the belief she entered the analysis with. As a result, self-confidence grows, but the quality of the assessment of the situation does not. When analysing a company it is therefore worth consciously leaving room also for information that does not fit the first impression. The firm's weaker sides, the risks visible in the results and the warning signals from the market environment are just as important as the arguments for buying. Only then does the assessment of the company become fuller and less susceptible to your own attitude.

Too much faith in your own judgement

Another common bias is excessive self-confidence. In investing it often appears after a few successful decisions, when an Elegant Investor starts to believe that she senses the market well and can accurately predict the development of the situation. A few profitable transactions or accurately assessed companies can make your own judgement start to seem more reliable than it really is.

On the stock market, however, the relationship between a decision and the result is not so simple. Good analysis does not always lead to profit right away, and profit itself does not always confirm the high quality of the earlier assessment. It happens that shares rise because the market environment, investors' moods or a good situation in the whole sector favours them. It also happens that a sensibly assessed company loses value for some time, although the firm itself still operates well, achieves good results and no signals of a clear worsening of its situation appear. For this reason a single result should not be treated as proof of your own exceptional accuracy.

Excessive self-confidence can lead to too bold decisions, the omission of part of the risks and weaker discipline in analysis. At a certain point the belief appears that since earlier choices turned out successful, the next ones can also be based more on a hunch than on a calm checking of the facts. In long-term investing a different approach serves much better, namely the awareness that even good analysis does not give full influence over the result, and the market can always turn out differently than we assumed.

What happens when you assess a company mainly through the lens of price

Very often Elegant Investors fall into the anchoring effect. It consists in the fact that one number starts to affect the assessment of the whole situation too strongly. Most often it is about the share price, which becomes the main point of reference, although in itself it does not yet give a full picture of the company.

Let us imagine that the shares of a given firm once cost 200 units of currency, and today they cost 120. For many people such a change immediately looks like an opportunity. Since the price was higher earlier, the current one may seem attractive. Except that the fall in price itself does not yet say whether the company is a good choice. The firm could have developed faster a few years ago than today. Its results could have worsened. The market could also have assessed its future differently, because the situation of the company itself or of the whole industry changed. The former price is therefore not enough to assess whether the current price is justified.

A similar mechanism appears when an Elegant Investor attaches herself too strongly to the price at which she herself bought the shares. If she bought them at 80 units of currency, and today they cost 60, she may start thinking mainly about the price returning to the earlier level. In such a situation a feeling appears that only then will everything be all right again and the decision will stop looking unsuccessful. The problem is that the current situation of the company does not depend on the price at which someone bought its shares. Much more important is how the firm operates today, what results it achieves and whether it still has the features that justified the purchase earlier.

This is exactly why, when assessing an investment, it is worth looking more broadly than only at the former price or at the price of your own purchase. The number itself can strongly attract attention, but it does not say everything about the quality of the firm, its situation and prospects. The sooner an Elegant Investor learns to separate the price from a fuller assessment of the company, the easier it is for her to keep greater order in her thinking and not make a decision under the influence of one point of reference.

Loss hurts more than gain pleases

One of the best-described phenomena in behavioural finance is loss aversion. In practice this means that a loss is felt more strongly than a gain of similar value. If someone loses 1000 units of currency, the emotional weight of this situation is usually greater than the joy of gaining 1000.

On the stock market this mechanism can strongly affect decisions. Some people sell shares that have risen slightly too quickly, because they want to keep the positive result and not risk the gain disappearing. Others, in turn, hold weak companies too long, because they do not want to come to terms with the loss having become real. In both cases the emotion takes the lead.

For a long-term Elegant Investor it is important not to assess every decision solely by whether the price momentarily rises or falls. Changes in prices are a natural part of the market. More significant is whether the firm still looks good from the point of view of the reasons for which the shares were bought earlier. If the firm still operates well, and the fall in the share price results from the situation on the whole market, the fall itself does not have to mean that the earlier decision was bad. On the other hand, a rise in price itself is also not proof that everything was assessed perfectly.

When others seem to know better

On the market the herd effect often appears. It means a situation in which the behaviour of other people starts to affect too strongly how you yourself assess a company and your own decision. If many people talk about one firm, praise it, show rises and emphasise its popularity, it is easy to get the impression that since so many people pay attention to it, something important must be behind it. In such a situation other people's self-confidence and enthusiasm can start to look like proof that a given company is a good choice.

For a beginner Elegant Investor this is sometimes especially hard, because at the start her own assessment is only taking shape. When admiration for one firm is seen from various sides, the thought may appear that others know more, understand the market better and noticed a good opportunity faster. Then the decision stops resting mainly on the analysis of the company, and more and more on the worry that something important is just passing by. A similar mechanism also works during falls. When many people start selling shares and talking about a threat, selling may start to seem sensible only because others are doing so. In both cases your own assessment of the situation moves to the background, and the emotions circulating around a given company start to play a greater role. This does not mean that other people's opinions should be ignored. It is worth reading analyses, getting to know different points of view and checking how others understand the firm's situation. You do, however, have to tell other people's opinion apart from your own assessment. The popularity of a company, large interest on the internet or frequent comments about it do not yet say whether the firm is well managed, whether it achieves good results and whether it fits a long-term approach. This is why in investing it is so important to understand what is in our portfolio and for what reason a given company found its way there at all.

How to limit the influence of cognitive biases

You cannot completely free yourself from cognitive biases. Every person is subject to them. You can, however, very clearly reduce their influence on decisions. Above all your own process of analysis helps in this. When an investor writes down why a given company interests her, what strong sides she sees, what risks she takes into account and what she will watch out for in the future, it is later easier to return to these assumptions and check whether the thinking is still coherent.

Separating facts from opinions also helps. A fact can be a rise in revenue, a fall in profit, a rise in debt or a change in margin. An opinion is what, on the basis of this data, we consider good or bad news. The more often we learn to recognise this difference, the easier it is to notice when a decision rests on data, and when mainly on an impression.

Patience also matters a great deal. The market often encourages an immediate reaction. New news, a strong move in price or a wave of emotions on social media appears. In such moments it is worth giving yourself time and returning to the question of whether something has really changed in the company itself, or whether only the mood around it has changed. This simple question can stop many hasty decisions.

The most important conclusions

Cognitive biases have a real influence on investment decisions, because they concern the way in which we look at information, risk and our own beliefs. They are not a sign of a lack of knowledge or a lack of ability. They are a natural part of human thinking, which is why it is worth being able to recognise them.

In long-term investing what matters is not only the choice of a company, but also the quality of the decision-making process. The confirmation effect, excessive self-confidence, anchoring, loss aversion and following the crowd can make even a sensible plan start to blur. The better we understand these mechanisms, the easier it is to return to the facts, analyse more calmly and not react solely under the influence of the moment. This is exactly why investment education should not end with learning financial ratios and definitions. It is just as important to understand how our mind works when money, uncertainty and expectations are at stake. For women who build their knowledge of the stock market from the basics, this is an important element of a more mature approach to investing. Elegant Investors show that an investor's development begins not only with getting to know the market, but also with attentively looking at her own decisions.

Sources:

Daniel Kahneman and Amos Tversky (research on cognitive biases and decision making), CFA Institute (investor education on behavioural finance, https://www.cfainstitute.org), Investopedia (definitions of cognitive biases and behavioural finance, https://www.investopedia.com), Morningstar (analysis of investor behaviour, https://www.morningstar.com), Behavioral Finance Working Group (research on behavioural finance), Harvard Business Review (articles on decision making and psychology, https://hbr.org), OECD (data and analysis on financial literacy, https://www.oecd.org)

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