Psychology of Investing: How Emotional Decisions Impact Your Portfolio

Introduction

“The investor’s chief problem—and even his worst enemy—is likely to be himself.”
— Benjamin Graham

In recent years, investing has gained significant traction among Indians, with the nifty 50 delivering impressive average annual returns of 15% over the past five years.

As more investors look to benefit from this growth, many are enthusiastic about exploring the opportunities in the investment landscape.

However, before making any financial decisions, it’s crucial for investors to first understand a key factor that often goes unnoticed—their own mindset, or what’s known as the psychology of investing.

As humans, we often rely on our instincts when things are uncertain. Whether it’s a sudden drop in the market or a stock that looks good, we tend to trust our gut feelings.

While instincts can be helpful in everyday life, they don’t always work well when it comes to investing.

When emotions drive our investment decisions, we often end up disappointed. We celebrate our wins when we follow our gut but forget about the losses that come from emotional decisions.

In investing, letting emotions decide our judgment can lead to poor choices.

To handle the challenges of investing, it’s important to understand behavioral finance and how it explains the psychological factors that influence our decisions.

By learning the different emotional biases that can impact our judgment, we can make smarter investment decisions and avoid common mistakes in investing.

Behavioral Finance

Behavioral finance explores how psychological factors and emotional biases influence the decisions of investors and financial experts.

Unlike traditional finance, which assumes people make rational choices, behavioral finance recognizes that emotions can lead to irrational actions, affecting overall market behavior.

By examining these behaviors and emotional biases, we can better understand the psychology of investing – why we make certain financial decisions and how those choices affect market trends and our overall financial success.

Types of Emotional Biases and How to Overcome Them?

There are six main emotional biases that can affect your investment decisions. Recognizing these biases and learning how to overcome them is important for making better financial choices.

1. Loss Aversion Bias

Loss aversion happens when the fear of losing money is much stronger than the happiness of gaining the same amount.

This bias often causes investors to hold onto losing investments too long or sell winning investments too quickly, just to avoid the emotional pain of a potential loss.

In the long run, this behavior can limit investor’s ability to achieve the highest possible returns.

What can you do?

• Focus on your long-term goals and avoid monitoring your portfolio obsessively.
• Accept that short-term losses are normal in investing, and don’t let them affect your strategy.
• Diversify your investments to spread risk.

2. Overconfidence Bias

Overconfidence bias leads investors to overestimate their abilities or knowledge, often resulting in excessive risk-taking.

This bias typically shows up after a series of successful investments, where investors start to feel invincible.

Overconfidence can lead to reckless decision-making, such as underestimating risks or concentrating too heavily on certain stocks or sectors, and not diversifying – which can result in significant losses.

What can you do?

• Regularly question your assumptions and acknowledge that market conditions are unpredictable.
• Avoid making decisions based on short-term success; always diversify your portfolio.
• Consult a financial expert to review and validate your strategies and assumptions.

3. Self-Control Bias

Self-control bias happens when investors prioritize short-term desires over long-term financial goals. This leads to behaviors like overspending or making impulsive investment decisions for immediate gratification.

Investors with self-control bias often save too little for long-term goals, like retirement, and may put too much money into assets that generate quick income, instead of having a balanced investment portfolio.

What can you do?

• Set up automatic transfers to savings and retirement accounts to ensure disciplined saving and investing.
• Create a budget that balances current spending with future financial goals.
• Regularly review and adjust your financial plan to stay on track.

4. Status Quo Bias

Status quo bias refers to the tendency of investors to stick with their current investments or strategies, even if they no longer serve their goals or if market conditions have changed.

This bias stems from a desire for comfort or familiarity, which can prevent investors from exploring better alternatives.

Holding onto outdated investments or failing to adjust portfolios over time can limit potential growth and performance.

What can you do?

• Periodically review your portfolio to ensure it aligns with your current goals and risk tolerance.
• Explore different investment options like mutual funds, stocks, foreign stocks, and bonds to potentially achieve better returns.
• Seek professional suggestions to ensure you’re not missing out on better opportunities due to comfort with the familiar.

5. Endowment Bias

Endowment bias occurs when individuals attribute greater value to assets simply because they possess them.

As a result, investors may hesitate to sell assets that no longer align with their needs, leading to an inconsistent asset allocation.

What can you do?

• Be objective about your investments and evaluate them based on their performance, not emotional attachment.
• Consider selling assets that no longer fit your financial goals, even if they hold sentimental value.
• Get a financial expert’s input to make rational decisions.

6. Regret-Aversion Bias

Regret-aversion bias happens when investors avoid making decisions out of fear that they will regret those actions later.

This leads to excessive caution, where investors prefer to stay on the sidelines rather than take a chance on potential opportunities.

Regret aversion can cause investors to miss out on significant market gains, as they overemphasize the fear of loss over potential reward.

What can you do?

• Understand that avoiding action can lead to missed opportunities, just like making the wrong choice.
• Stick to a disciplined investment plan, even in uncertain times.
• Take calculated risks and focus on long-term goals rather than short-term market movements.

How to Protect Your Money from Emotional Biases?

Even when we understand the psychology of investing, it’s human nature for our feelings to sometimes overshadow our rational decision-making.

Overcoming these biases to build a solid portfolio can be particularly challenging in the current market landscape, both in India and globally, where new promising sectors like AI create a sense of urgency and complexity in decision-making.

To protect your investments from the effects of emotional biases, one of the most effective strategies is to seek expert guidance for your investment decisions.

A straightforward approach is to incorporate mutual funds into your portfolio, tailored to your risk profile.

This allows you to leverage the expertise of professional fund managers who make informed buy and sell decisions based on market conditions. 

Their knowledge and experience help ensure that emotional biases don’t cloud their judgment.

Additionally, according to data from the Association of Mutual Funds in India (AMFI) the value of assets held by individual investors in mutual funds grew from ₹27.15 lakh crore in August 2023 to ₹40.36 lakh crore in August 2024, reflecting an impressive increase of 48.67 percent.

This impressive growth reflects the increasing popularity and confidence that investors have in mutual funds.

But how can you choose the mutual funds that best align with your goals and risk tolerance?

What if you had a financial expert to manage your mutual fund transactions for you?

Having a financial expert to assist you with your mutual fund investments adds an important layer of protection against emotional decision-making.

This collaboration fosters open discussions about your investment strategy, ensuring you make informed choices.

This is where Moolaah comes in—an investment services platform that connects you with a financial expert who is an AMFI-registered mutual fund distributor.

Moolaah provides an extensive list of financial experts to choose from.

You can review their experience and expertise to select the one that best suits your needs, and they will manage your investment executions for you—at no cost.

With professionals handling your investments, you’re less likely to fall victim to emotional biases.

Moreover, one of the key preventive measures against emotional biases is diversification.

With Moolaah’s extensive range of products—mutual funds, stocks, foreign stocks, bonds, fixed deposits, and portfolio management services (PMS)—you have a single platform to manage all your investments.

This centralized approach makes it easy to track and manage your investment portfolio.

With expert guidance and a diversified portfolio, you can minimize the impact of emotional biases on your investment decisions and improve your chances of achieving financial success.