The psychology of investing

26 June 2024

There’s more to managing your money than budgets and bank accounts. To make the most out of your finances, consider the range of factors that can influence the way you spend, save and invest – from your emotions and behaviours to your inherent biases.

It’s something John found out the hard way after recently deciding to dip his toe into investing for the first time. “It was just after a cryptocurrency called Dogecoin had experienced a huge surge in value, and quite a few of my mates had made thousands overnight,” explains the Sydney-based FIFO worker. “I’d never invested in anything before, but I jumped on Reddit and it was the same thing there – people making a lot of money from this coin that had exploded.”

Seduced by the positive outcomes, John created a profile on an online crypto-trading platform and quickly dumped $2000 into Dogecoin. “You don’t have to be an economist to predict what happened next,” he says. “Of course, by the time I got in, it was too late. It came crashing straight back down to earth and I lost about 75 per cent of my investment.”

Fighting off FOMO

John’s story highlights a trap that many inexperienced investors fall into: FOMO (fear of missing out) investing. “Try to avoid FOMO investing and make decisions based on your own analysis and strategy, not just because everyone else is doing it,” says Ryan Felsman, a senior economist at CommSec. “The last thing you want to be is reactionary.”

While it’s natural to experience FOMO from time to time – and it’s important to follow trends and watch the market – investors driven by FOMO may find themselves buying at the peak of the market or with a share portfolio that lacks diversification and balance.

Of course, that’s not to say your emotions should be kept completely outside the ring when it comes to financial decisions. As much as remaining rational may make sense, it isn’t always practical. According to Evan Lucas, author of behavioural economics book Mind Over Money, there’s a more realistic middle ground: be reasonable.

“If we were to act economically rational, we’d be doing things all over the place that were sometimes against our own interests,” Lucas says. “For example, it makes rational sense that the younger we are, the more we should invest in the equities market.

“But when we’re young, we also want to have families so the decision to spend money on our kids instead of investing might not be a rational one but it’s a reasonable one. The trick is knowing how to balance the two.”

Know your weaknesses

Lucas points to the work of Daniel Kahneman, author of Thinking, Fast and Slow, who explores “loss aversion” – essentially that people fear losing money more than they value building it. He says this is one of the key psychological traits holding back would-be investors.

“We’re much more attuned to losing $10 than we are to making $20,” he says. “If you know you had $50 in your pocket and you put your hand in there and find nothing, you’ll fret over that $50 longer than the elation you’d feel if you had forgotten it was there, reached in and found a windfall of $50.”

Other mental stumbling blocks for investors include common biases. “Confirmation bias is where a person undertakes their research with a preconceived idea of the facts and seeks information that will reinforce that belief,” says Lucas. “Recency bias is where people have limited information and use it to predict that recent events will recur. These are human nature so it’s less about overcoming natural instincts and more about being aware of them and using the tools we have available to counterbalance rash, emotion-driven investment decisions.”

Felsman agrees. “The thing we can do to manage our finances objectively is, firstly, to make sure we diversify investments across location, sector and asset class. And recognise your own emotional responses to the market to choose an investment strategy with a focus on your own risk tolerance levels and goals.”

Tip: Outsmart your mind

“My top tip is automation: take the decision away from yourself,” says Lucas. “Compound interest works and history tells us it will continue to work into the future. If you can decide to put some money – whether it’s $100 or $500 per month – into an account that automatically invests your money, that gets around the problem of loss aversion and then your finances are always in motion.”

Tip: Keep your eyes on the horizon

“Look to the long term and adopt an appropriate investment strategy,” says Felsman. “That gets you off the emotional roller-coaster of short-term market volatility and allows you to diversify and educate yourself along the way. You might like to consider active funds, which are managed funds offered by portfolio managers and these can be diversified. They can invest in shares, property, bonds, cash, commodities and the like, so that when one goes up and the other goes down, you can smooth out any event risks across your portfolio.”

Got 20 minutes?

Tune in as host Jamila Rizvi chats to the CommSec team and breaks down the world of investing on CommSec Invest: The Share Market Simplified. Listen wherever you get your podcasts. 

Things you should know

An earlier version of this article was published in Brighter magazine

This article provides general information of an educational nature only. It does not have regard to the financial situation or needs of any reader and must not be relied upon as personal financial product advice. The views expressed by contributors are their own and don’t necessarily reflect the views of CBA. As the information has been provided without considering your objectives, financial situation or needs, you should, before acting on this information, consider the relevant Product Disclosure Statement and Terms and Conditions, and whether the product is appropriate to your circumstances. You should also consider whether seeking independent professional legal, tax and financial advice is necessary. Every effort has been taken to ensure the information was correct as at the time of printing but it may be subject to change. No part of the editorial contents may be reproduced or copied in any form without the prior permission and acknowledgement of CBA.