Business

The 14 stages of investor behaviour

The Sterling Report

BY Lisa Minto

Sunday, March 17, 2019

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Behavioural Finance is the study of investor behaviour, which endeavours to understand and explain how investors think, act and why they do what they do. Most investors understand the concept of buying low and selling high. However, because they allow fear, greed and other emotions to influence them, they tend to stray from their principles, and this affects their decisions.

Efficient markets assume that investors are thinking rationally and are making rational decisions regarding their investment decisions. It is assumed that they are executing transactions with an intent to reap the greatest gains and the lowest losses while keeping the concept of buying low and selling high in the back of their heads. In addition, they utilise the findings of their research and other details relevant to making a decision.

Investors are not always rational thinkers though, and this reduces the efficiency of the market.

Even investors who understand behavioural finance can still be victims of this rollercoaster. However, increased familiarity will help us to avoid getting stuck in these stages. Eventually, all investors will aim to master their emotions and maximise their ability to invest rationally.

By understanding the stages of this cycle, we can understand where in the cycle we fall and tame the emotional rollercoaster, we may find ourselves on. There are 14 stages according to stock trader.com. However, the theory is based on several behavioural finance books which include: Shefrin, Hersh. Beyond Greed and Fear, Understanding Behavioural Finance and the Psychology of Investing, and Kahneman, Daniel and Tversky, P rospect Theory: An Analysis of Decision Under Risk, among others.

The 14 stages along the market psychology of investing are:

1. Optimism – In this state, a positive attitude and outlook drives us to invest in the market — expecting to be well rewarded for our efforts.

2. Excitement — When our expectations match our rewards, it provides encouragement which is just the incentive we need to invest and acquire more in the market space.

3. Thrill — This is when we as investors cannot believe our own success and begin to believe our own press.

4. Euphoria — This marks the point of maximum financial risk. It is common to believe that having been so successful, that you now have the Midas touch and every trade you touch will be profitable, regardless of any obvious risks or red flags.

5. Anxiety — This is when our portfolio starts to experience unrealised losses. However, we convince ourselves that we are long-term investors and that all our ideas will eventually work.

6. Denial — Similar to grief, when the losses persistent, we do not know what to do, and as a result we begin denying either that we made poor choices or that things will not improve shortly.

7. Fear — At this juncture, there is the feeling that things will never improve, the portfolio is doomed.

8. Desperation — Here, we grasp at any idea that will allow us to get back to breakeven.

9. Panic — Having exhausted all ideas, we are at a loss as to what our next move should be.

10. Capitulation — At this point, we sell all our stocks to avoid any future losses.

11. Despondency — Once we have managed to sell the portfolio at a loss, we decide that we never want to buy stocks ever again. Unfortunately, this is the time that the financial opportunity is at its highest.

12. Depression — Not knowing how we could be so foolish, we are left trying to understand our actions.

13. Hope — Eventually we return to the realisation that markets move in cycles, and we begin looking for our next opportunity.

14. Relief — Having bought a stock that turned profitable, we renew our faith that there is a future in investing.

So, the question is: where are you in this cycle?

Have you watched friends or family go through these stages? Do you think you can skip some of them and in so doing, avoid making irrational decisions? Examine past decisions and assess the effect of your emotions on those investments.

One added bonus is that a thorough understanding of behavioural finance can give you a leg-up on the market when you can predict the behaviour of others.

Lisa Minto is the AVP, Financial Planning at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm


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