Roller Coaster Ride for Typical Investors
The diagram illustrates the journey of a hypothetical investor navigating the ups and downs of the stock market, showcasing several psychological biases. As the market rises, reaching record highs, our investor, influenced by bullish media coverage highlighting success stories and omitting failures (confirmation bias), decides to participate to avoid missing out (trend-chasing). Fueled by overconfidence, the investor believes failure is unlikely, emboldened by the prevailing narrative.
Searching for investment opportunities, the investor prioritizes well-known names frequently mentioned by friends or the media (availability bias). When choosing a promising pharmaceutical stock, the investor focuses solely on positive reports, overlooking risks (confirmation bias). Historical success further convinces them of the stock’s reliability (representative bias). The investor is intrigued by a report framing a 20% chance of outperforming the market positively, while ignoring the less favorable 80% projection (framing effect).
Initially, the investment performs well, reinforcing the decision to act quickly. However, as negative news surfaces, the investor discounts it (conservatism bias). During a market correction, they buy more stock, anchoring decisions to initial prices. The stock continues to fall, but the investor holds on, unwilling to sell at a loss (disposition effect). Mental accounting and sunk cost bias exacerbate the irrational behavior, leading to increased anxiety.
When the losses become unbearable, the investor sells, declaring, “I’m done with equities!” Feeling validated by subsequent minor price drops, they justify their decision. As the stock rebounds, the investor hesitates, doubting the recovery (hindsight bias). Eventually, the rally restores optimism, and they reinvest, thinking it’s cheaper than before (anchoring again).
This story highlights how cognitive biases—anchoring, confirmation, framing, and others—lead private investors to buy high and sell low, often resulting in significant financial losses over time. Recognizing and mitigating these biases is crucial for making rational investment decisions.